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Bonds vs. Stocks: Understanding the Difference

September 27, 2020 · 8 minute read

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Bonds vs. Stocks: Understanding the Difference

If you’re a beginning investor, you’ve probably been told that the best way to diversify your portfolio is with a blend of stocks and bonds, and that the mix you choose should be based on your age, your tolerance for risk, and your overall financial situation.

You also likely have heard that stocks can be riskier, but have the potential to offer the highest gains, while bonds are generally safer and more reliable.

But if that’s as far as the lesson went—whether it came from a parent, a friend, a financial professional, or a website—you may still have questions about the differences between these key investment options and what each has to offer as you work toward your goals.

Here’s a quick look at the basic differences between stocks and bonds.

What Are Stocks?

When you purchase a company’s stock, you become a part owner, and that entitles you to a share of its earnings and assets. How much you own depends on how many shares you hold in relation to the total number of shares held by others.

There are two main types of stocks—common and preferred.

•  Common stocks give shareholders voting rights regarding company policies and who should be on the board of directors, but there’s no guarantee that the investor will receive dividend payments.

•  Preferred stocks generally don’t include voting rights, but these shareholders receive payouts and dividends before common shareholders. And there’s less chance that they’ll lose their investment if the company goes out of business.

Common and preferred stocks can fall into one or more categories:

•  Income stocks pay consistent dividends, so they provide reliable income.

•  Blue-chip stocks offer ownership in established companies with a solid history of growth.

•  Growth stocks have earnings that are growing faster than the market average. They rarely pay dividends, so most investors buy them with the hope of profiting from capital appreciation.

•  Value stocks are shares that are trading at a lower price than an investor might anticipate given the company’s history and performance. The stock may have fallen out of favor for some reason, but since shares can be acquired at a relatively low cost, investors may buy them hoping the price will rebound.

Stocks can also be categorized by size, as shown by their market capitalization. There are large-cap, mid-cap, small-cap, and micro-cap stocks.

There are two basic ways to make money with stocks.

One is to buy stock in a company and then sell it for a higher price than was paid. That might be two months later, two years later, or two decades later—depending on an investor’s needs or plans.

Those who stick with their stocks over long periods of time—known as a buy and hold strategy—are often rewarded with positive returns. But there is no guarantee that an investment will grow.

If the market tanks or a business goes belly up, investors can lose money, too. So you may want to do a little comparison shopping—checking on a company’s financial health and its real value—before making any decisions.
Another way an investor can get income from stocks is through the regular distributions some companies pay their shareholders, called dividends.

Dividends are corporate earnings that companies pass on to their shareholders—and they can be a sign of stability. Typically, larger, older corporations have the financial strength to pay dividends, while younger, still-growing companies may not (often because they’re reinvesting the money in the business).

But even the most profitable public corporations have no legal obligation to pay dividends to common shareholders, no matter how much cash they have—and dividends do get cut from time to time.

What Are Bonds?

A bond is kind of like an IOU: Instead of buying a share of ownership, investors are lending money to the 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.

Bonds can provide a predictable income stream, but 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. If the bond issuer is doing well, the investor could see a capital gain. If not, the sale might be made at a loss.

Interest rates also can affect bond values. 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 you buy a bond when interest rates are high and then interest rates go lower, you 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. This only matters if you’re trying to sell your bond before it matures.

There are three main types of bonds:

•  Corporate bonds: These are debt securities issued by private and public corporations. Within this category, there are investment-grade bonds which have a higher credit rating, and high-yield bonds, which have a lower credit rating. The credit rating reflects the amount of risk that’s involved. Because high-yield bonds have a lower credit rating, which implies there’s more risk, they usually offer higher interest rates. (More risk, more reward.) However, there is a greater chance of ‘default’, where the company cannot pay the interest or principal on the bond that you are owed.

•  Municipal bonds, or munis, are issued by states, cities, counties, and other government entities. They can include:

◦  General obligation bonds, which are backed by the “full faith and credit” of the issuer.

◦  Revenue bonds, which are backed by revenues from a designated project or other source.

◦  Conduit bonds, which are municipal bonds issued on behalf of private entities such as nonprofit colleges or hospitals.

•  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. These popular investments include:

◦  Treasury bills, which are short-term securities, longer-term notes that mature within 10 years.

◦  Bonds, which typically mature in 30 years and pay interest every six months.

◦  Treasury Inflation-Protected Securities (TIPS), which are notes and bonds whose principal is adjusted based on changes in the Consumer Price Index. TIPS pay interest every six months and are issued for five, 10, or 30 years.

So Which is the Better Choice?

There is no one right answer. Each has its pros and cons.

A lot depends on where you are in your life (often referred to as a time horizon), as well as how much risk you are capable of absorbing both financially (without jeopardizing your goals) and emotionally (so every market fluctuation doesn’t make you a nervous wreck).

Stocks give investors the greatest potential for growth over time, but they also come with more risk. 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.

And stocks can be affected by factors—good and bad—outside a company or industry’s control, including the economy, global events, politics, and even the weather.

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.

There’s a possibility that a bond issuer won’t be able to repay the bond when it matures, but investors can mitigate that risk by choosing from the most creditworthy issuers. And if an issuing corporation does go bankrupt, bondholders still can expect to be the first to be repaid, before preferred stockholders.

Bonds can provide reliable income—which can be especially welcome in retirement, when a person’s regular paycheck goes away. And some even have a tax advantage—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. Check with a tax professional to learn if you are eligible for these benefits.

The main risk for bonds comes with the interest rate fluctuations mentioned above, and with an investor’s need to keep up with inflation.

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.

Both stocks and bonds come with some liquidity risk, as well. If an investor has to sell an investment during a down market—for income after a job loss or in retirement, for example—they may have to do so at a loss if the pool of buyers has dried up.

Investing in the market can be thrilling—in ways both good and bad. You never know how long the good times will last, or how low things can go in the bad times.

Because no one can predict what the market will do, a mix of stocks and bonds is typically considered a great way to build a portfolio.

One that’s too heavily weighted with stocks may be vulnerable to volatility. One with too many bonds might not generate returns that can keep up with the cost of living. But a balanced asset allocation can provide income and growth.

That doesn’t mean every investor should go with a 50-50 approach. Or even the traditional 60/40 portfolio that for decades has been the conventional way to provide moderate-risk, long-term growth in a retirement portfolio.

Variables to consider when looking at asset allocation include age, goals, risk tolerance, investment experience, tax implications, and how long the person intends to invest.

Younger investors, for example, who are in the “accumulation phase” of investing, may choose to use stocks, ETFs, and mutual funds to help them grow their money for retirement and other goals. If the market corrects—or worse—they have more time to recover before moving into retirement.

Those who are nearing retirement are in what’s called the “preservation phase.” They may decide to continue investing for growth, but with less time to recoup their losses in the case of market decline, they might also want to take down the risk a notch or two and move toward more safety in their portfolio.

And even those in retirement—the “distribution phase”—may find adjustments are necessary in order to avoid depleting their savings faster than they planned.

How do you invest in stocks and bonds?

When you’re ready to invest, you have a few choices for how to go about it.

You can buy stocks and bonds through a broker-dealer or a Registered Investment Advisor. You also can buy some bonds, including Treasury bonds, directly from the issuer. Some companies allow investors to buy or sell stocks directly through them without using a broker, but there are often limits on these plans.

New investors often start by buying a mutual fund or exchange-traded fund (ETF) that offers a bundle of stocks and/or bonds. With this approach, investors rely on a professional fund manager to choose a diversified mix of securities that suits their needs instead of trying to do it on their own.

Whatever route you choose, it pays to be mindful of the fees involved, because they can eat away at returns. Common fees to look out for include commissions, expense ratios, and advisory fees.

If you want affordable access to a range of investment options, and maybe a little hand-holding along the way, a SoFi Invest® account may have what you’re looking for. You can trade stocks and ETFs yourself with active investing, and/or let SoFi build a portfolio around your preferences and goals with automated investing.

SoFi Invest doesn’t charge transaction or management fees. And SoFi members have complimentary access to financial advisors, so you can ask, “What’s the difference between stocks and bonds?”—or any other question—without worrying about how much the conversation is costing.

Plus, SoFi makes the process as painless as possible with the SoFi app. You can be as hands-off or as hands-on as you like, keep track of your progress, and get up-to-date investing news in real-time.

SoFi can help you understand both what you’re doing and how you’re doing as you invest.

If you’re interested in how stocks, bonds, and other investment tools can keep your money working for you, check out SoFi Invest.

SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

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