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Bonds vs. Stocks: Understanding the Difference

May 17, 2021 · 5 minute read

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Bonds vs. Stocks: Understanding the Difference

One of the biggest challenges for investors is figuring out the proportion of assets within their investment portfolio.

But instead of thinking stocks versus bonds, or which asset is a smarter decision, it can be a good idea for an investor to consider them as parts of a portfolio that perform complementary roles.

Here’s a deeper dive into each of these asset classes and how to think about what role they play in an investment portfolio.

Stocks

Stocks, which are small pieces of ownership of a company, offer a greater earning potential to investors than other asset classes. We’ve all heard of investors who bought shares of a company three decades ago, which has since soared to extraordinary heights.

But while stocks can be relatively easier to understand, they are also one of the more riskier asset classes. Stock volatility can be a reality for investors as everything from economic report, earnings season to geopolitical events can move the market.

Bonds

Bonds can be an area in which investors are less familiar than stocks. Think of bonds like an IOU. Instead of buying a share of ownership like you would with a stock, a bond is created when an investor lends money to the issuer.

This is how bonds work. In return, those investors are promised a specified rate of interest during the life of the bond and that the issuer will repay the whole amount lent when it matures.

Corporations, the federal government, municipalities, and other issuers sell bonds to raise money for various purposes—to fund a new project or expansion, for example, or to juice the returns of the equity holders through leverage.

Some investors may already have bond exposure in their 401(k), depending on how they allocated or auto-directed their portfolio. But because bonds have a large face value (usually $1,000 or higher) many investors don’t buy individual bonds the way they may choose to buy shares of individual stocks. Instead, many investors invest in bonds via bond mutual funds or exchange traded funds (ETFs).

Different Types of Bonds

•  Corporate Bonds: These are debt securities issued by private and public corporations. Corporate debt can either be investment-grade, or deemed by ratings firms as less likely to default, or high-yield or junk bonds. There are pros and cons to high yield bonds. They’re more volatile and likely to default, but also deliver greater returns.
•  Municipal Bonds, or munis, are issued by states, cities, counties, and other government entities. These may have a tax advantage as well. For example, the interest from municipal bonds is generally exempt from federal income tax, and it may be exempt from state and local taxes in states where the bond was issued.
•  U.S. Treasury Bonds are issued by the Department of the Treasury and backed by the full faith and credit of the U.S. government.

Comparing Stocks and Bonds

Stocks and bonds perform different roles in a portfolio. Here are some of the attributes of equities:

•  Growth Potential: Stocks give investors the greatest potential for capturing the growth of a company over time. However, there’s no way to know if a stock will grow, or if its price will be affected by an unsuccessful product launch, a change in management, or a scandal.
•  Liquidity: For investors, stocks are an appealing investment because they are liquid, or relatively easy to buy and sell. All investors typically have to do is sign onto their brokerage account and submit a buy or sell order.
•  Dividend Payments: Dividend-paying stocks can provide an income stream for investors and can also provide an avenue to reinvest in the market.

Meanwhile, bonds may provide an investor the opportunity for:

•  Less Volatile: Bonds are usually considered safer than stocks because the investor is more apt to get the fixed interest payments promised, even if the value fluctuates over time. Bonds don’t have the money-making power that stocks have, and the safest bonds typically have the lowest returns. If an investment isn’t keeping up with inflation, the investor’s purchasing power is declining.
•  Income Stream: Bonds can be one way to provide guaranteed portfolio income rather than relying on dividends alone. Bonds also may have a tax advantage.
•  Preserving Wealth: If a bond is held until maturity, the bond holder could be guaranteed their money paid back. This can be a way to hold onto capital while still investing. A bond holder isn’t required to hold onto a bond until it reaches its full maturity. A bond can be sold through a broker at any time.

Inverse Performance of Stocks and Bonds

Here’s another reason why an investor may choose to have both stocks and bonds within their portfolio: their performances tend to be inversely correlated. This means that generally, when stock prices are high, bond prices are low, and vice versa.

But interest also plays a role in the value of bonds within a portfolio. For example, in a historically low-interest rate environment like the one we’re in now, the value of bonds is a topic of discussion among investors.

If you buy a bond when interest rates are low and then interest rates rise, your bond will likely fall in value because investors expect a higher interest rate than what you originally received. To incentivize them to buy your bond, you have to lower the price.

Conversely, if an investor buys a bond when interest rates are high and then interest rates go lower, the investor can likely sell your bond for a higher price than where you purchased it. Prices and interest rates tend to go different ways – higher interest rates result in lower bond prices and lower interest rates result in higher bond prices.

Recommended: Federal Reserve Interest Rates, Explained

The 60/40 Rule

Conventional wisdom has always been that bonds provide portfolio diversification as well as providing stability against stock market performance. In general, investors may start with a lower percentage of bonds when they’re younger, because they have plenty of time to make up losses if the market were to drop.

As an investor gets closer to retirement age, they may reallocate their portfolio to have a larger percentage of bonds, so that any market fluctuations won’t have as extensive an impact on their portfolio and they have an income stream they can rely on.

Recommended: When Can I Retire Formula

In the past, conventional wisdom suggested a 60/40 rule of 60% stocks to 40% bonds. But the low-interest rate environment, coupled with the stock market performance, may have investors rethinking whether this “rule” applies to their portfolio.

For many investors, the best asset allocation depends on multiple factors:

•  Your age
•  Your risk tolerance
•  Your portfolio goals

The Takeaway

Even if stocks tend to dominate news headlines, bonds can play an important role in an investor’s portfolio. And there’s no real competition between stocks and bonds because both asset classes play an important role in a diversified investment portfolio.

As a general rule of thumb, the ratio of stocks to bonds can depend on an investor’s unique financial goals, age, and other factors. Having an understanding of bonds and becoming familiar with the bond market can be helpful as you make financial decisions.

Getting exposure to both stocks and bonds through ETFs is possible with SoFi Invest®. Investors can either pick and choose which type of stocks or bonds they want by using the Active Investing platform. Or they can sign up for Automated Investing, which will allocate to bonds and stocks depending on the risk exposure an investor wants.

Get started on SoFi Invest today.


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