Stocks and bonds are quite different. Stocks give investors the opportunity to buy a share of ownership in a company; bonds are a contract where the investor loans a company or entity funds, with the guarantee of repayment within a certain period of time, at a certain interest rate.
Many people compare stocks vs. bonds because these two asset classes — equities and fixed income, as they’re known — are two key building blocks for most portfolios. Because stocks typically move in a different direction than bonds, having both as part of your asset allocation can provide diversification.
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 easy to understand, they are also one of the riskier asset classes. Stock volatility is a reality for investors, as everything from economic reports to earnings season to geopolitical events can move the market.
💡 Quick Tip: When people talk about investment risk, they mean the risk of losing money. Some investments are higher risk, some are lower. Be sure to bear this in mind when investing online.
For various reasons, investors tend to be less familiar with bonds and the bond markets. Think of bonds as similar to an IOU. The way bonds work is that instead of buying a share of ownership as you would with a stock, a bond is created when an investor lends money to the bond issuer.
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.
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).
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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. Investors who stick with equities for the long haul can reap the benefits of the stock market’s average return. 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.
• Lower taxes: Some bonds offer tax advantages. For example, you typically don’t owe state or local taxes on the earnings from state government bonds; some municipal bonds are tax free.
• 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.
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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.
The 60/40 Rule
Conventional wisdom has 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 stock 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.
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In the past, conventional wisdom suggested a 60/40 rule of 60% stocks to 40% bonds. But a low-interest rate vs. a high-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
💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.
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.
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