We often hear the terms “stocks and bonds” used interchangeably, as if they’re two sides to the same investment. They’re not. In fact, they’re very different investments, but they’re often used in the same sentence because they complement one another.
The differences between stocks vs. bonds are pretty dramatic.
And that’s precisely why it’s usually best to hold both in your investment portfolio. While there are certain distinct similarities, they often provide different benefits in different types of market environments.
Most financial experts recommend that you have a portfolio balanced between the two.
Other allocations, like cash, real estate, and commodities, may be recommended, but stocks and bonds are typically the primary investments. Let’s take a look at both, and why you need them in your portfolio.
What Is the Difference Between Stocks and Bonds?
In theory, stocks and bonds counter each other. Stocks represent equity in companies and have the potential to generate capital gains. Bonds provide safety of principal and stable income.
Beyond that distinction, there are a number of differences between stocks and bonds.
Understanding those differences can help you balance your investment portfolio, using both stocks and bonds strategically to maximize returns.
What Are Stocks?
Stocks represent ownership in a business enterprise and are issued in denominations referred to as shares. Each share represents fractional ownership in a company.
For example, if a company has 1 million shares of stock outstanding, each share represents one-millionth ownership in the company.
Stocks can be either publicly or privately issued. If they’re publicly issued, they trade on stock exchanges, like the New York Stock Exchange or the NASDAQ.
If they’re privately issued, they’ll be held by a small group of individuals, each with a substantial percentage of ownership in the business.
Why Companies Issue Stock
Companies issue stock as a way of raising capital, typically to expand a business.
For example, the business might issue 1 million shares of stock at $10 each. That will raise $10 million in capital.
A company can choose to raise capital by issuing stock, rather than going into debt by getting a loan from a bank or issuing bonds, which would create an obligation for the eventual repayment of the loan or bonds with interest.
Investors buy stock to have an ownership stake in what they believe will be a profitable company. Companies sometimes pay dividends on stocks. But investors might be more interested in the price growth potential of the stock than anything else.
The Benefits of Owning Stocks
Stock investors look to make money in one of two ways, and sometimes both:
- From dividends paid on the stock, and/or
- Capital appreciation on the stock price.
For example, a stock might pay an annual dividend of 3%. But it may also have the potential to rise by 10% or more annually. This can happen if the company shows a steady pattern of both rising revenues and increasing profits.
In fact, based on the S&P 500 index, stocks have returned an average of about 10% per year between 1986 and 2016. There’s even some evidence that rate of return goes all the way back to 1928.
Keep in mind however that the return includes both dividend yield and capital appreciation. But that’s just the average return. The 10% average return is just that – an average. There have been stretches of several years where the market has provided much higher returns.
The Risks of Owning Stocks
Stocks tend to grow very slowly over time, or even trade in a narrow range.
Here are some factors that could cause a stock to fail:
- Laws: The passing of laws or regulations that are unfavorable to the company or to one of its primary products or services.
- Lawsuits: A lawsuit against the company.
- International risks: Currency risks for a company with substantial international operations.
- Malfunction: The failure of an important product line or service.
- Competition: The arrival on the market of a superior competitor.
- Spending: The company might cut or suspend its dividend.
- Donwsizing: The withdrawal of a major client (or several clients) of the company.
- Market changes: A general decline in the financial markets, which can have an especially severe impact on an individual company.
- Industry advances: The development of a technology that renders one or more of the company’s products obsolete.
That’s just a few samples of what can go wrong with a stock. Each represents a risk that the investor takes in buying shares in a particular company.
Different Types of Stock
When we talk about stocks, we’re not talking about a single type of stock. There are actually several. Some examples include:
Common stock: This type of stock represents a general ownership stake in the company. Common stockholders elect the company’s board of directors and vote on corporate policy. But in the event of liquidation, they get in line behind bondholders, preferred shareholders, and other individuals and entities with superior lien positions.
Preferred stock: These shares usually don’t have voting rights. But preferred stockholders are eligible to receive dividends before they’re paid to common stockholders. Preferred stock functions somewhat like bonds, in that they have fixed dividend payments. But unlike bonds, they also offer the potential for capital appreciation.
Growth stock: This is the stock of a company that invests its profits primarily in growing the business. The stock may not pay a dividend, or offer only a very small one. Investors in growth stocks are betting primarily on capital appreciation, not income.
Dividend stock: The company behind this type of stock pays out much of the company’s profits in dividends to shareholders. The stock may offer some amount of capital appreciation, but the primary attraction is the dividend yield. That yield is often higher than what’s available on bonds and short-term debt securities.
Value stock: These are stock in companies that are considered out-of-favor with the general investing public. Investors might buy into these companies if their fundamentals are strong (despite the share price drop), or if it looks like they’ve turned the corner and are improving.
Investing in Stocks Through Funds
While it’s common to invest in individual stocks, investing in funds has grown in popularity in recent years. There are two primary types of investment funds:
Mutual Funds: These are portfolios of stocks, often representing major companies in an industry, which regularly add new stocks while selling off others. Because of this activity, they often generate more taxable capital gains and they usually carry higher fees, often referred to as “loads”.
Exchange Traded Funds (ETFs): These are funds that invest in stock market indices. An ETF will invest to match that index. As a result, stocks will turn over in the fund only when the index is reconfigured. They tend to generate far less capital gains than mutual funds. And because they have less activity, they charge much lower fees. ETF usually don’t have load fees.
Why Many Investors Prefer Investing in Stocks Through Funds
An investor might invest in a fund to simplify stock investing. The investor can purchase shares in a fund, which represent a portfolio of stocks. There’s no need for the investor to pick individual stocks, and manage the portfolio.
Funds simplify investing and also work to spread investment risk.
If you purchase an individual stock, the price could tank. But if you buy into a fund, there can be dozens or even hundreds of stocks in the fund. A collapse of any one (or even several) won’t dramatically impact your investment.
Funds also provide an opportunity to invest in specific market segments. For example, an investor can choose to invest in high-tech, healthcare or energy. She can also choose domestic or international stocks.
There are even sector funds that invest in companies by size. Those include the following:
- Large-cap stocks: generally companies with a market capitalization greater than $5 billion.
- Mid-cap stocks: generally companies with market capitalizations between $1 billion and $5 billion.
- Small cap stocks: this sector is made up of companies with market capitalizations of less than $1 billion.
At each phase of a bull market, companies of any of these three size classifications could outperform the others. Sector funds provide an opportunity for investors to take advantage of that situation.
What Are Bonds?
Bonds are debt obligations of an institution issued at a fixed face amount, with a certain term, and a specific rate of interest.
The issuer can be a corporation, the federal government, state, county or municipal governments, or foreign governments.
Bonds are issued in denominations of $1,000. For example, a corporation may issue a $1,000 bond with a 5% interest rate (referred to as a “coupon”). Interest will be paid on the bond every six months, at $25 per payment.
Generally speaking, they are longer-term interest-bearing securities of more than 10 years. However, investors may casually refer to any interest-bearing security as a “bond”.
Shorter-term debt securities actually go under different names. For example, a security with maturity between one year and 10 years is generally referred to as a “note.” Securities with maturities of less than one year are “bills”, or various proprietary titles.
Bank issued certificates of deposit typically run between 30 days and five years and are never referred to as bonds.
Why Companies and Governments Issue Bonds
Corporations: A corporation may issue bonds to pay for plant and equipment, the acquisition of another business entity, or to consolidate other debt.
Governments: Governments may issue bonds to finance capital improvement projects, pay general obligations, or retire other debts.
One of the main features distinguishing a bond from a stock is that as the holder of a bond you do not have an ownership stake in the company. The bond represents a debt obligation, and once it’s paid off, the issuer’s obligation to you ends.
The Benefits of Owning Bonds
The basic purpose of owning bonds is to create a steady income stream, with preservation of capital.
Interest income: The interest paid on bonds provides the income stream. Unlike dividends, bond interest is fixed. If a company issues a 20-year bond, the rate will continue for the full term. This makes the income stream from the bond completely predictable. And because they’re longer-term securities, bonds generally pay higher rates than bank investments.
Preservation of capital: Safety of principle is the other primary goal. As long as a bond is held to maturity, the full face value of the security will be paid by the issuer.
Investment diversification: Because bonds pay a fixed rate of interest and guarantee principal payment at the end of the term, they’re generally considered safer than stocks, typically held as a diversification to stocks in a well-balanced portfolio. Bonds help the portfolio retain value during stock market downturns.
The Risks of Owning Bonds
There are four primary risks involved in owning bonds:
Default by the issuer: A corporation could go out of business, leaving its bonds worthless. And while the occurrence is rare, even municipal governments can default on their bonds. In the event of default or bankruptcy, a bondholder may get less than the face of the amount of the bond, or even face a period of time when interest payments would be suspended.
Inflation: Say you purchase a 20-year bond at an interest rate of 4%. With an inflation rate of less than 2%, that’s a solid return. In the next few years, the rate of inflation rises to 5%. You’re now getting a negative rate of return on your bond. With inflation at 5%, and the interest rate of 4%, you’re losing 1% per year in real terms.
Currency risk: This is a risk that applies to foreign bonds, whether issued by foreign corporations or governments. Bonds are typically issued in the currency of the issuer’s country. Should the value of that currency drop against the US dollar, the value of your bonds could fall.
Rising interest rates: Bonds have an inverse relationship with interest rates. When interest rates fall, bond prices rise. When interest rates rise, bond prices fall. Accelerating inflation will cause higher interest rates. Depending upon how close you are to the maturity date, the value of a $1,000 bond might fall to something like $700 if you were to sell it on the open market.
Different Types of Bonds
This is where bonds get a bit complicated. To invest in bonds, you need to understand the variety of types available to you.
Corporate bonds: As the name implies, corporate bonds are bonds issued by corporations for various purposes.
Convertible bonds: These are also corporate bonds, but they come with a provision enabling them to be converted to company stock. They can be converted at specific times to a certain amount of stock. The bondholder can choose to make the conversion.
High-yield bonds: Once called “junk bonds”, these are bonds paying higher interest rates, by issuers with low credit ratings. It’s a classic example of a higher return/higher risk investment.
U.S. Government bonds: Treasury bonds are issued in terms of 20 and 30 years by the US Treasury Department, with shorter-term securities issued for as little as four weeks. They can be purchased in denominations as low as $100 through Treasury Direct. and are consider the safest of all investments with their government backing.
Municipal bonds: These are securities issued by states, counties, and municipalities. The primary attraction is that the interest paid on these bonds is tax-free for federal income tax purposes. The interest is also generally tax-free in the state of issuance, but not in other states.
Foreign bonds: These are bonds issued by foreign governments and corporations. Investors may purchase them because they pay higher interest rates than domestic bonds. They have all the risks of other bonds, but also foreign currency risk.
Investing in Bonds Through Funds
Because of high face values, and the fact that bonds often must be purchased in minimum amounts (like 10 bonds for $10,000), it can be difficult for all but the wealthiest investors to diversify adequately. That’s why bond funds are often preferred by smaller investors.
The same $1,000 that would purchase only one bond, can have an interest in dozens of bonds in a bond fund. That lowers the risk that comes with holding a single bond.
Bond funds also offer an opportunity to invest in specific types. For example, you can invest in a fund that holds only high-yield bonds. You can also choose to invest in a fund that holds bonds that are within a few years of maturity.
The Differences Between Stocks vs. Bonds
The main differences between stocks and bonds are straightforward, but some of the differences between the two can be a bit blurred.
For example, there are stocks that pay dividends that are equal to or higher than bond interest. Bonds also have the potential to generate capital gains in a financial environment where interest rates are falling. (It’s that inverse relationship with interest rates bond have, but with a positive outcome.)
How Bonds Can Behave Just Like Stocks
Because of interest rate risk, long-term bonds can often behave like stocks. I just explained how bond values can rise in a declining interest rate environment. But we’ve also covered the major risk that rising interest rates pose to bonds.
If a bond has 20 or more years to run, it can behave a lot like a stock. It can rise and fall with changes in interest rates and inflation. What’s more, stocks also tend to be interest rate sensitive.
Since interest-bearing investments compete with stocks for investor capital, rising interest rates often have a negative impact on stocks. (They also raise the cost of borrowing for the company, lowering its profits.) Falling interest rates have a positive impact.
In that way, stocks and bonds can actually perform in a similar way.
There’s no shortage of places to trade stocks and bonds and we will talks about then in another post.
Why You Need Both: Investing in Both Stocks and Bonds
The basic reason to invest in both stocks and bonds is to balance equity participation with capital preservation. Exactly how much you should hold in bonds is an ongoing debate. There are only theories.
One is that your stock holdings should represent 100 minus your age. Under that formula, if you’re 30 years old, 70% of your portfolio would be invested in stocks, and the rest in bonds. Conversely, a 70-year-old would have 30% in stocks (100 – 70), and 70% in bonds.
That looks a bit too conservative for the 30-year-old. But it might be a good mix for the 70-year-old.
Another is that your stock holdings should represent 120 minus your age. Under that formula, a 30-year-old would have 90% in stocks, and 10% in bonds. Conversely, a 70-year-old would have 50% in stocks (120 – 70), and 50% in bonds.
That sounds about right for the 30-year-old, but it might be a bit too aggressive for the 70-year-old.
Should you use either of the formulas above?
I’d say use them only as a starting point. You also have to take into consideration your own risk tolerance.
If you’re 30 years old, you might not be entirely comfortable having 90% of your portfolio in stocks. That being the case, lower the stock allocation somewhat until you’re more comfortable with the mix.
Whatever formula you use, a well-balanced portfolio has both stocks and bonds – and at least a little bit of cash.
Properly allocated, it can maximize growth, while minimizing risk. That’s the whole reason you need both stocks and bonds in your portfolio.