If you're just starting your investment journey, understanding the basics of stocks and bonds is crucial. Both are widely used by investors to build wealth, but they have distinct characteristics, risks and benefits. In this guide, we break down each type of investment, explore their roles in building a portfolio and show how you can balance them for long-term success.
What Are Stocks?
When you purchase a stock, you buy a small share of a company. Stockholders become partial owners of the company, entitled to a portion of the company's profits and, in some cases, voting rights on key business decisions.
In exchange for this ownership, stockholders take on the risk that the company's stock price may rise or fall, depending on its performance and broader market conditions.
Common vs. preferred stocks
Common stocks are the most typical type of stock and provide voting rights in company decisions. Common stockholders are last in line for payouts if the company goes bankrupt, after debt holders and preferred stockholders. However, they can earn money if the company grows, either by the stock's value increasing or by receiving part of the company's profits as dividends.
Meanwhile, preferred stockholders typically do not have voting rights but have priority over common stockholders when it comes to dividend payments and claims on company assets if the company liquidates. Preferred stocks usually pay fixed dividends, which makes them more reliable for steady income than common stocks but less likely to grow significantly in value.
Example: A common stockholder in a company like Apple can vote on major decisions, like electing board members. But if Apple went bankrupt, common stockholders would only receive money after preferred stockholders and debt holders had been paid.
Domestic vs. international stocks
Domestic stocks represent companies based in your home country. International stocks are issued by companies abroad, and investing in them offers exposure to global markets. International stocks often add diversity to your portfolio but can introduce risks like currency fluctuations and political instability.
Example: Buying stock in Amazon provides exposure to the U.S. market, while investing in Alibaba offers access to China's rapidly growing tech sector, exposing you to different economic conditions.
Growth vs. value stocks
Growth stocks are shares in companies expected to grow at an above-average rate compared to other companies. These stocks usually don't pay dividends, as the companies reinvest profits to fuel further growth. While growth stocks can offer substantial long-term gains, they also come with higher volatility and risk.
Value stocks, on the other hand, are shares in companies that appear undervalued compared to their earnings, dividends or other fundamentals. These companies may not be growing as rapidly, but they're considered stable. They are often priced lower than their intrinsic value, providing potential for future growth at a lower risk.
Example: A company like Tesla is often considered a growth stock, as it's investing heavily in future technologies like electric vehicles and renewable energy, with the potential for high returns but considerable volatility. In contrast, a company like Johnson & Johnson is considered a value stock, offering stable earnings, reliable dividends and lower risk due to its established market position in healthcare.
How To Buy Stocks
Stocks can be purchased through online brokerages or investment apps. These platforms have made it easier than ever to invest in stocks with just a few clicks. While investing in individual stocks can offer higher potential returns, it also comes with significant risk due to market volatility.
The role of stocks in a portfolio
Stocks are typically used for growth. While they can be volatile, their long-term performance tends to outpace inflation and offer higher returns compared to other asset classes like bonds. Including stocks in your portfolio can help you grow wealth faster, especially if you invest for the long term.
Example: If you invest $10,000 in the S&P 500 index (a broad measure of U.S. stock market performance) and it returns an average of 7% annually, you could see your investment grow to $19,671 in 10 years. That growth potential is why stocks are a key component of retirement accounts like IRAs or 401(k)s.
READ MORE: How Do I Research a Stock Before Investing?
What Are Bonds?
A bond is a debt security—meaning when you buy a bond, you're lending money to a government or corporation in exchange for periodic interest payments (known as the coupon) and the return of the principal amount at the bond's maturity. Bonds are generally considered safer than stocks because they offer fixed returns and have a lower likelihood of losing value.
Government bonds
These bonds are issued by national governments and are generally considered one of the safest investments, as they are backed by the government's promise to repay. For example, U.S. Treasury bonds are supported by the "full faith and credit" of the U.S. government, which minimizes the risk of default.
Example: A 10-year U.S. Treasury bond might offer a 2% annual return, guaranteed by the U.S. government. If you purchase $10,000 worth of bonds, you'd earn $200 annually, and at the end of 10 years, you'd get your $10,000 back.
Corporate bonds
Corporate bonds are issued by companies to raise funds for various business needs, such as operations or expansion. These bonds typically offer higher returns than government bonds to compensate investors for the additional risk of lending to a business rather than a government.
Example: If you buy a bond from a company like Tesla, it may offer a 5% yield to attract investors, as the company's financial stability isn't as secure as the government's.
Municipal bonds
Municipal bonds (or “munis") are issued by state, local or other governmental entities to fund public projects, like schools, roads or infrastructure. They often offer tax advantages, with interest earned on them typically exempt from federal taxes (and sometimes state and local taxes). Munis are considered safer than corporate bonds, but they offer lower returns.
Example: A city issues a municipal bond to fund the construction of a new public hospital. If you purchase a $10,000 bond with a 3% annual interest rate, you’d earn $300 annually, and the interest may be exempt from federal income taxes, depending on where you live.
High yield (junk) bonds
High yield bonds, often referred to as "junk" bonds, are issued by companies or governments with lower credit ratings. These bonds offer higher interest rates to compensate for the increased risk of default. They can be appealing to investors seeking higher returns, but they come with a higher level of risk.
Example: A startup company with a low credit rating might issue a high yield bond to raise funds. While these bonds may offer a 7% interest rate compared to the 3% on a government bond, the risk of the company defaulting on its debt is higher, making them riskier investments.
How To Buy Bonds
Bonds can be purchased directly through brokers or bond funds, which pool together various bonds. Direct purchases may be more cumbersome for small investors, so many choose bond funds for more liquidity and diversification.
The role of bonds in a portfolio
Bonds are generally used for income generation and risk mitigation. While they offer lower returns than stocks, they provide a predictable income stream and can act as a counterbalance to stock market volatility. Bonds are often favored by conservative investors, such as those approaching retirement, who prioritize stability.
Example: A retired individual might hold a portfolio made up of 60% bonds to generate income and 40% stocks to provide growth. If the stock market falls in value, the bond portion of the portfolio can help offset losses.
READ MORE: CDs vs. Bonds: Key Differences & How to Compare Your Options
Stocks vs. Bonds: Risk and Return Comparison
- Stocks carry higher risk but also higher potential returns. A well-chosen stock may increase dramatically in value over time, providing strong growth. However, stocks are susceptible to price swings driven by market conditions and company performance.
- Bonds are generally considered lower risk. The risk of losing principal is minimal unless the bond issuer defaults. Bonds tend to offer fixed returns (interest), which are often lower than stock returns. While this provides stability, the lower returns can be less attractive for those seeking high growth.
Example: In 2020, the stock market saw significant fluctuations due to the pandemic. The S&P 500 dropped by 34% in March but rebounded by 70% as of December. Meanwhile, bonds generally maintained their value, providing more stability and steady income for those who were risk-averse during uncertain times.
READ MORE: Investing in a Bear Market
How economic conditions impact investment choices
Market conditions play a significant role in the performance of both stocks and bonds. For example, rising interest rates can cause bond prices to fall because newer bonds offer higher yields, making older ones less attractive. In contrast, lower interest rates can boost stocks by spurring consumer spending and business investment.
Example: When interest rates are low, it can be a good time to buy bonds, as bond prices are likely to rise. But if the economy is booming, stocks may be the better option to capture that growth.
Why diversification matters
Diversification is the practice of spreading investments across different asset classes to reduce risk. By holding a mix of stocks, bonds and perhaps other assets (like real estate), you can mitigate the impact of a downturn in any single area.
Example: If you have a portfolio that's entirely in tech stocks, a market correction in that sector could harm your returns. However, if you diversify with bonds and international stocks, a downturn in one area may be offset by growth in another.
READ MORE: Personal Finance 301: Asset Allocation and Diversification
Tailoring your portfolio to your goals
Your stock-to-bond ratio depends on your investment goals and risk tolerance. Younger investors with a long-term horizon typically invest more heavily in stocks for growth, while those closer to retirement might favor bonds for stability.
Example: A 30-year-old saving for retirement might have 80% of their portfolio in stocks and 20% in bonds, allowing for more risk and higher potential rewards. Meanwhile, a 60-year-old might shift that ratio to 40% stocks and 60% bonds to preserve capital while still maintaining growth.
Rebalancing your portfolio
Over time, market fluctuations may cause your portfolio to drift away from its original allocation. Rebalancing ensures that your investment mix aligns with your current goals and risk tolerance.
Example: If your portfolio was initially 70% stocks and 30% bonds, but stock market growth caused stocks to grow to 80% of your portfolio, you may want to sell some stocks and buy bonds to return to the original balance.
Start Investing Today
Whether you're new to investing or looking to fine-tune your strategy, understanding stocks and bonds is the first step to building a strong portfolio. By balancing risk and return with a diversified mix of investments, you can set the foundation for steady, long-term growth of your wealth.
READ MORE: 10 Lessons You Should Learn Before Investing
