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.
Key Points
• Stocks represent ownership and offer growth potential, but come with higher volatility and risk.
• Bonds function as loans, providing fixed returns and lower risk, contributing to portfolio stability.
• Market conditions influence stocks and bonds differently, with interest rates impacting bond prices inversely.
• In portfolio diversification, stocks and bonds each play a role in balancing risk and returns.
• Financial goals, age, and risk tolerance should guide the allocation of stocks and bonds in an investment portfolio.
What Are Stocks?
Stocks are small pieces of ownership of a company, and for investors, may offer the opportunity to generate returns. 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.
Key Characteristics of Stocks
There are different types of stocks, with the most common being, well, common stocks. Some key characteristics of common stocks include voting rights, potential dividends, and the ability to buy and sell them quickly, or that they’re highly liquid. This isn’t the case for all stocks.
What Are Bonds?
You can 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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Types of Bonds
Like stocks, there are different types of bonds. Some of the key types are corporate bonds, which are issued by companies, and government bonds, which may be issued by either local governments, or the federal government.
Government Bonds vs Corporate Bonds
Here’s a bit more about how government bonds and corporate bonds compare and contrast.
• 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.
Key Differences Between Stocks and Bonds
Stocks and bonds perform different roles in a portfolio. Here are some of the attributes of equities:
Growth Potential of Stocks vs. Bonds
Stocks generally 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.
Bonds, on the other hand, generally don’t offer the same type of growth potential.
Risk and Volatility Comparison
Stocks tend to be volatile, relative to bonds. That’s why bonds are usually considered less risky 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.
Liquidity of Stocks vs Bonds
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. Both are relatively liquid investments, though, and are easy to trade.
Stocks vs Bonds in Different Market Conditions
Stocks and bonds tend to have inversely-correlated performances. 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 low-interest rate environment, 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 when 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.
Performance in Bull vs Bear Markets
During bear and bull markets, respectively, stocks and bonds tend to behave differently. For instance, during bull markets, stock values tend to rise, and they tend to fall during bull markets. The opposite generally happens for bonds — but not in every instance, and not for every single asset.
The 60/40 Portfolio Strategy: Balancing Stocks and Bonds
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
Portfolio Diversification Strategies
There are a host of ways you can diversify your portfolio, and it may be best to hash out a plan with a financial professional depending on your specific goals. But to give you an idea of what those strategies might look like, investors might diversify across different asset classes, across industry lines, or even within asset classes and industries. Investors can also look at alternative investments, regular rebalancing tactics, and more.
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.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
Which is riskier: stocks or bonds?
Stocks tend to be higher-risk investments compared to bonds, as they’re more volatile.
How do I know when to invest in bonds or stocks?
You may not ever know for sure when to invest in one asset class versus another, and it may depend entirely on your investment strategy, your risk tolerance, and your time horizon.
How do interest rates impact bond prices?
Bond prices and interest rates generally have an inverse relationship, which means that bond prices fall when interest rates rise.
Can I lose money investing in bonds?
It is possible to lose money when investing in bonds (or anything else, for that matter). Bonds have risks, such as credit risk, and the issuer could default and stop making interest payments to the bond holder.
What is the relationship between inflation and bond returns?
Bond returns tend to fall when inflation goes up, or prices increase, because the interest payments holders receive (which is fixed), has less purchasing power. So, buying bonds may be less attractive to investors during times of high inflation.
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