What’s the Difference Between Stocks and Bonds?
In 2022, 58% of surveyed Americans said they own stocks. Most were from households with annual earnings of $100,000 or more. However, 25% of stock-owning respondents made under $40,000 a year.
Stocks aside, corporate bonds are also among the most popular investment assets. While not as exciting as stocks, they’re a worthy addition to anyone’s portfolio.
Experts also say 2023 could be a good year for the U.S. bond market. This is welcome news, considering 2022 was its worst year.
But what exactly is the difference between stocks and bonds? Which one should you invest in, and why?
We’ll address all those questions in this guide, so read on.
Primary Difference Between Stocks and Bonds
Stocks provide investors, even regular folks, a means to buy a part of a company’s ownership. Bonds allow investors to lend money to a corporate or government entity.
So by investing in stocks, you become a partial owner of a company. By contrast, buying bonds turns you into a debtee who a debtor owes money to.
How Do Stocks Work?
Stock investments give partial ownership of a company in the form of equity. Think of it as buying a small slice of the company or, in stock terminology, a “share.”
The more shares you buy, the bigger the slice of the company you own.
For example, Company A sells 1,000 stocks representing 10% of its ownership at $100 per share. In this case, each share equals 1/1,000 of that 10%.
You then purchase $5,000 worth of stocks, or 50 shares ($5,000 divided by $100 per share). So, you’d own 50/1,000 of the 10% the company sold in stocks.
Then, over the next few years, the company where you own those shares performed well. As a result, the price of their stocks increased to $150 per share. This also raised your investment’s value from $5,000 to $7,500 (50 shares times $150 per share).
In that scenario, your investment has grown by 50%. You can then decide to keep your current stocks or buy more. Alternatively, you can sell the ones you own at their current price, giving you a profit of $2,500.
However, remember that the opposite can happen to the company you invested in. If it performs poorly, its stock prices can also plummet. As a result, your investment’s value also drops, and you risk losing money.
Stocks can also lose all their market value, especially when companies go bankrupt. The good news is that U.S. bankruptcy filings have consistently decreased. For instance, 2021 only saw 14,347 business bankruptcy filings, compared to 23,157 in 2017.
What About Bonds?
Bonds are loans you, as an investor, make to another company or a government. So when you buy bonds, you won’t get equity or ownership of a company. Instead, you only “lend” money to the entity you purchased bonds from.
With bonds, your earnings come from the interest paid to you by the entity. How much it is depends on the types of bonds and their maturities.
Usually, the higher the bond value, the higher the interest, too. That’s because you, as the lender, assume a more considerable risk by lending more money.
Likewise, the longer the maturity, the higher the interest usually is. After all, this means you must wait longer to recover the money you lent.
Suppose you buy a bond for $5,000 that pays a 3% annual interest for 15 years. So every year, the entity you purchased the bond from should pay you $150 in interest payments. The debtor may pay you monthly installments of $12.50 each or a $150 lump sum annual payment.
In that scenario, you should get $2,250 in total interest payments for 15 years. You should also get your initial $5,000 investment back after your bond’s maturity.
Which Provides Higher Return Potential?
The U.S. stock market’s annual return rate is about 10%, at least as of 2022. It has performed better than that for many years but also poorly in others.
Overall, though, stocks provide a higher return potential than bonds. The U.S. bond market’s 10-year long-term average is only 4.25%.
Which Is Riskier?
The stock market’s higher return potential also means it has a higher risk of losses.
Bonds tend to be less risky since they come with the issuer’s promise to return their face value. So even if you’d earn less interest, you have a lower risk of losing your initial investments.
Also, if you buy bonds, you’d know how much money you can expect from your investments. That’s because you and the bond issuer had agreed on the annual interest payments.
What if the bond issuer goes bankrupt or out of business before your bond’s maturity date? In this case, you may lose money. However, if the company has any more left, it’s your right to recover yours before stockholders.
The U.S. bond market has also historically been less vulnerable to volatility. That’s why their prices don’t fluctuate as wildly as those for stocks.
However, remember that specific types of stocks and bonds are generally higher risk.
That’s why you should do your homework and research your options based on your risk tolerance. Otherwise, you may lose all your investments. Indeed, the folks at My Investing Club say that 90% of traders fail due to improper education.
Which Should You Buy?
Ask any savvy investor about their stock or bond strategy, and they will tell you to get both. A good enough reason is that this can help diversify your portfolio and spread your risks.
For instance, when you buy stocks, you can enjoy the potential of earning higher returns. However, you want to balance them with a more stable asset because they come with a higher risk. Bonds are ideal for this, as they have historically been stable.
Please note that portfolio diversification isn’t a fool-proof way to prevent complete losses. Neither will it guarantee gains. However, it can help you control your risks better and give you more potential for higher returns.
Invest in Both Stocks and Bonds
Now you know that the chief difference between stocks and bonds is that the former is for equity. It affords you partial ownership of a company. Bonds don’t do that as they’re more like loans, but they can still earn you money through interest payments.
So, to diversify your portfolio, consider buying both stocks and bonds.
For more savvy tips to manage your portfolio, check out our guide on making it inflation-proof!
