You've probably heard the terms stock and bond, but what exactly are they? Simply put, stocks and bonds are two types of investments that can be included in an investment portfolio. Invest in stocks or bonds with the expectation of a return, which means that over time you will have more money than you paid in. But stocks and bonds are very different things that serve different purposes in a diversified investment portfolio.
What are Stocks?
Stocks are direct investments in companies. When you buy stock or shares in a company, you are buying part of the company. You own part of the business. This means that as the value of the listed company increases, your share of that value increases. On the other hand, if the value goes down, the value of your shares will go down. If the company makes a big profit and decides to give some of that money to its owners, you will receive a dividend.
What are Bonds?
Bonds are basically an investment in debt. Bonds are a way for the government and companies to raise funds: they are small loans to large entities. For instance, if a city wants money for a park, it can now sell bonds and pay buyers interest. This gives the city the money it needs, and it will be paid back with interest over time. You can keep the title and get your money back on time or sell it to someone else ahead of time.
Bonds versus Stocks
What are the pros and cons of stocks versus bonds? Should you invest more in stocks or bonds? Let's see how each works:
Stocks
If you are looking for a higher profitability opportunity, you should consider stocks. But with the higher earning potential comes even more risk. Stocks fluctuate with the markets.
Say you bought a $1,000 share of a small tech company that sells products online (let's call it TechSlr). Over the next 15 years, TechSlr became a household name, generating billions of dollars in sales each year. The value of your shares has been multiplied by 100. You could sell your shares and walk away with $100,000. However, it is also possible for the stock price to fall below what you paid. Or that the company you invest in goes bankrupt in a year, and you have nothing left.
Bonds
Bonds issued by the United States federal government and investment bonds are generally stable investments. They pay constant interest over time (also called coupon payments), and the entities are unlikely to disappear before the maturity date or the date the debt plus interest matures.
Suppose you buy $1,000 worth of bonds from a large corporation. The company agrees to pay you 4% annual interest for 10 years. Unless the company goes bankrupt or is in serious financial trouble, you might be able to get exactly what the company promised and walk away with $1,400 ten years later. But because bonds tend to be safer, you won't have the ability to earn a high return like you would with stocks.
Unlike stocks, bonds are debts that the business owes you, not an investment, so the interest and value of the bond are not tied to the market value of the business. Bond prices also move in the opposite direction to interest rates. So if interest rates rise, you can sell your bonds for less (for example, a $1,000 bond might cost $900) because investors can buy new bonds at higher interest rates.
How are Bonds different from Stocks?
Bonds are debt investments, while stocks are a way to buy part of a business. Stocks and bonds also offer different levels of risk and return on investment. Let's look at the pros and cons of investing in each.
Advantages and disadvantages of stocks
Stocks can be very profitable investments as they have the potential to generate high returns over a long period. They tend to grow with the economy and can help you keep pace with inflation. Because stocks are riskier, losing money is easier, especially if you invest in individual stocks.
Advantages and disadvantages of Bonds
Generally, bonds tend to be lower-risk investments than stocks and often offer a higher interest rate than you would get if you put your money in the bank. The downside is that there are no rewards, and interest payments can only keep up with inflation. They are also generally more expensive than stocks, as most bonds are sold in $1,000 increments, so there is a higher barrier to entry. Lower-rated bonds, such as junk bonds, are exposed to default risk.
Investing in stocks and bonds for retirement
Finally, the best investment strategies use a combination of stocks and bonds (and sometimes alternatives such as cash, commodities, or real estate) to balance risk and reward opportunities. And you don't have to invest directly in individual stocks and bonds. You can also buy mutual or exchange-traded funds that invest money in a wide variety of stocks, bonds, and alternatives.
If you are close to retirement, you will generally want a higher percentage of your portfolio in stable assets, such as bonds. Speak to a qualified financial advisor to make sure you are on the perfect track for retirement.
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