Ever hear people talking about investing? A lot of times you may have heard of the famous 60/40 stocks and bonds portfolio. What’s the difference between stock and bonds though? Well, that’s what we’re about to settle here once and for all. By the time you finish reading this, you’ll know what the difference is and whether you want to invest in either of them.
Stocks are a type of equity investment which are defined as investments through the ownership of a business or property. By owning stock, an investor owns a partial share of the company that the stock represents. Bonds are a type of debt investment. Debt investments get their value by loaning money to another business or person and collecting that money back with interest.
Let’s dig in deeper to get a better idea of each of these.
Stocks – Being a Part Owner of a Company
If you own stock, you own part of a company. That?s because stocks represent a share of a company. If you purchase stock from that company, you are purchasing ownership that is proportional to the number of shares you own. Someone that owns 100 shares of company Y, owns 10 times as much of the company as someone that only owns 10 shares.
Just like with bonds, you have to balance your Risk/Reward. Investing in well-established companies with proven financial success will be more stable and generally earn a smaller amount of money at a more consistent pace. Investing in newer companies that are less established will usually see more swings in price and you can generally make more in a short amount of time but there is risk that you can also lose more in that same amount of time.
Stocks change value constantly. Bonds are generally fixed and usually only change based on interest rates that don?t change often. A stock?s worth is dependent on the company?s performance which is constantly scrutinized. The better a company is doing financially, the more the stock price will rise. When it has a run of bad news or has an earnings report that is less than expected, the stock price may fall.
Stock is generally traded by buying and selling shares from one person to the next in the open market and generally require a stock broker to manage the transaction.
Options and Futures are often thought of as stock trading methods but really they are from a third form of investing known as Derivatives. I’m not going to go into derivatives here because we’re focused on stocks and bonds. Options and Futures are very complex and not generally for the beginning trader.
That being said, a lot can be made trading these markets if you have the time to learn about them in more detail. Because stock prices change daily, they are considerably riskier but generally have the potential to make a considerable amount more as an investment.
Bonds – Making Interest Income from Debts
When you buy bonds, you are basically loaning money in exchange with a receipt that promises to pay back your loan at a predetermined time with a predetermined interest rate. You can choose to purchase a bond from a company, corporation and sometimes even the government itself.
Similarly, to stock, bonds are traded on the open market. That means that if you have a bond, you can sell it to someone else and they assume the risk of the investment. Likewise, you can purchase a bond from someone else so you don?t have to physically engage with the company, corporation or government agency yourself.
One thing to note is that the value of bonds is directly influenced by interest rates. If you ever see the news regarding finance, interest rates are discussed frequently and almost every time bond will be brought up in the same discussion. For instance, if general interest rates rise, your bond may be worth less because the interest rate determined for that particular bond when it was generated, will be worth less. Here?s an example:
You have a $1000 bond with Company X at 4% interest. The interest rates for the economy were at 3%. As long as the economy stays neutral, your bond is relatively unaffected. Your bond is an investment and it is outperforming the market by 1%. Now interest rates rise to about 5%. Your bond will drop in value because it is now appreciating at a lower rate than the market. Hopefully, that makes sense. If not, please leave a question in the comment section below and I can help clear it up!
With bonds, you are not overly concerned with the company?s success due to quarterly statements and yearly sales. These are issues that concern stock owners. Instead, you are only concerned with the agreed-upon return rate which is the percentage of the bond at the original time of offer. It?s a fixed rate called the coupon rate.
One thing that is very important to know though is what?s called the maturity date. This is the date that the bond payment is given to the investor. Every bond is different. Some bonds may require 30 years to mature.
If you buy a bond that was a 30-year bond at the time of creation, it doesn?t mean you necessarily have to wait 30 years to receive payment because your bond may have been created 25 years ago and only has 5 years left to mature. Remember, you can trade bonds on the open market.
What?s the downside? Like all investments, there is some risk. That risk is that the company could go bankrupt and not pay you back! You need to ensure that you invest in bonds from a company or corporation that is trustworthy. If you are looking for a safer bond, you can look to invest in government bonds or well-established companies that have a proven track record (these are generally referred to as Blue Chip companies.)
If you are not afraid of taking risks and want something that pays out a little more, you can choose companies with lower credit rankings or a less proven record. The rates of return of these are usually higher because there is greater risk attached to them. The market is generally a fair place. Like all investments, there is a trade off for Risk/Reward. It?s up to you how much risk you want and what types of returns you?re aiming for.
Are Stocks or Bonds Better?
I can?t tell you which is better to trade because stock and bonds are different and everyone has different investment needs. What I can say is that there is always a balance between risks and reward and only you can determine where you want to be in that relationship.
Being aware of the risks and understanding how stock and bonds work will make you a more informed investor and that?s really what?s important.
Most financial advisors will recommend a blend of stocks and bonds so that you can benefit from the growth of stocks and the safety of bonds. As we get older, we become more risk-adverse and tend to need our investments to be a little on the safer side. After all, we don’t want to be 70 years old and then the market crashes leaving our retirement cut by 30% in a few days.
By adding bonds to our portfolio as we get older, we cushion ourselves from these type of “black swan” events. A common rule you’ll hear about is the Rule of 100.
In order to use this rule, take your age and subtract it from 100. Whatever is left over should be invested in stocks and the rest should be in bonds. If you’re 38 years old, that means 38% of your portfolio should be in bonds and 62% should be in bonds (100 – 38 = 62).
I think this is a little too conservative personally so I use the rule of 110 and just shift it over a little bit. It’s completely up to you though! Ultimately, do your own research and come up with the best ratio for you!
Hopefully you have a better idea of what the differences are between stocks and bonds. If you want to get started with investing in stocks, check out my article on how to get started. If you want to look more into bonds, check out TreasuryDirect.
Lastly, if you want a service that manages and adjusts your stock/bond ratio for you, check out a roboadvisor like Acorns or Betterment.
Until next time, take care and let’s start investing!