Stocks and bonds are two common types of investments. Stocks represent an ownership stake in a company. Bonds are debt. They are are two different ways companies fund and expand operations. Let's see what that means for you, the investor.
Stocks Represent Ownership
Stocks are simply ownership shares of corporations. When a company issues stock, it is selling a piece of itself in exchange for cash.
Suppose a corporation makes it through the startup phase and becomes successful. The owners wish to expand, but they are unable to do so solely through the income they earn through their operations. As a result, they turn to the capital markets for additional money.
One way to do this is to split the company into shares. Then, they can sell a portion of these shares on the open market in a process known as an initial public offering, or IPO.
Note
When you purchase a stock, you're buying an actual share of the company. This makes you a partial owner. That's why stock is also referred to as "equity." This applies to established companies and IPOs that are new to the market.
Bonds Represent Debt
Bonds, on the other hand, are debt. When an entity issues a bond, it is issuing debt with the promise to pay interest for the use of the money.
Note
A government, corporation, or other entity that needs to raise cash will borrow money in the public market. Then, it will pay interest on that loan to investors who have loaned them the money.
Each bond has a certain par value (say, $1,000) and pays a coupon to investors. For instance, a $1,000 bond with a 4% coupon would pay $20 to the investor twice per year ($40 annually) until it matures.
After it matures, the investor is returned the full amount of their original principal. If, for some reason, the issuer is not able to make the payment, the bond will default. This rarely happens.
The Difference for Investors
Each share of stock represents an ownership stake in a corporation. That means the owner shares in the profits and losses of the company, although they are not responsible for its liabilities. Someone who invests in the stock can benefit if the company performs very well, and its value increases over time.
At the same time, they run the risk that the company could perform poorly and the stock price could fall. In the worst-case scenario, the company may file for bankruptcy and even disappear altogether.
Important
Individual stocksand the overall stock markettend to be on the riskier end of the investment spectrum in terms of their volatility and the possibility of the investor losing money in the short term. However, they also tend to provide superior long-term returns. Stocks are favored by those with a long-term investment horizon and a tolerance for short-term risk.
Bonds lack the powerful long-term return potential of stocks, but they are preferred by investors who want to increase their income. They also are less risky than stocks. While their prices fluctuate in the market—sometimes quite substantially in the case of higher-risk market segments—the vast majority of bonds tend to pay back the full amount of principal at maturity, and there is much less risk of loss than there is with stocks.
Which Is Right for You?
Many people invest in both stocks and bonds to diversify. Deciding on the appropriate mix of stocks and bonds in your portfolio is a function of your time horizon, tolerance for risk, and investment objectives. Typically, stocks and bonds do not fluctuate at the same time.
If seeing a stock price fall quickly would cause you to panic or if you are close to retiring and may need the money soon, then a mix with more bonds could be the better option for you.
If you're a young investor who has a lot of time, you can benefit in a weak market. You can buy stocks after their prices drop, and sell them when their prices increase again.
Each person has their own financial goals. Try to keep them in mind when choosing which investments to make.
Frequently Asked Questions (FAQs)
What percentage of my portfolio should be in stocks vs. bonds?
The recommended portion of stocks and bonds in your portfolio changes depending on your circ*mstances. If you start investing when you're young, you can put a larger percentage of your portfolio in stocks because of the long-term reward, which will mitigate the risk of stock volatility. As you get closer to retirement, you'll want to gradually shift toward more bonds to offset the growing short-term risk.
What happens to stocks and bonds when a company goes bankrupt?
If a company files for bankruptcy, it must pay back its debts before its shareholders. That means bondholders are in a better position to get paid back than investors when a company is in trouble.
How do you buy stocks and bonds?
To buy stocks, you must set up a brokerage account, establish funds, and then begin trading. You can do this online, through a stockbroker, or directly from companies. Bonds typically require a larger minimum investment and can be purchased through a broker, an exchange-traded fund, or directly from the U.S. government.
FAQs
A stock makes you an owner of a business. The value of that business is based on it's future profits, which are unknown. A bond is a loan to a business or a government. The value of the bond (the bond is an IOU for the loan) is based on the amount of interest it will pay you until the loan is re-paid.
What are the differences between stocks and bonds? ›
Stocks are ownership shares in a company, while bonds are a kind of loan from investors to a company or government.
What is the difference between a stock and a bond quizlet? ›
A stock is a certificate of ownership that can be purchased, sold, and traded. A bond is a certificate of debt that government organizations or businesses in the private sector use to raise capital.
How is a bond different from a stock responses? ›
A stock is an investment in a company. Your investment (purchased in shares) can grow or decline based on the company's success. A bond is an investment in a company's or government's debt. After you purchase a bond, the entity develops a plan to repay the principal of your investment with interest.
Which of the following describes a difference between stocks and bonds? ›
Which best describes the difference between stocks and bonds? Stocks allow investors to own a portion of the company; bonds are loans to the company. Which of the following would be considered the highest risk portfolio? A portfolio made up of 60% stocks, 30% mutual funds, and 10% Treasury bonds.
Which of the following are differences between a bond and a common stock? ›
Stock represents a share of ownership in a corporation. A bond is a security that represents a debt owed by the corporation to the bondholder, but does not include the ownership privileges of a stockholder.
What is the difference between preferred stock and bonds? ›
The difference is that preferred stocks pay income in the form of a dividend, whereas bonds pay interest and the return of principal at maturity. Preferred stock is sensitive to fluctuations in interest rates. Like bonds, when interest rates rise, the price of preferred shares typically falls as their yields increase.
What is one difference between stocks and bonds ________? ›
The greatest difference between stocks and bonds are their risk levels and their return potential. Speaking very generally, stocks have historically offered higher returns than bonds but also come with increased risk. While you may earn more with stocks, you may also stand to lose more.
What is the largest difference in stocks and bonds Quizlet? ›
What is the largest difference in stocks and bonds? Stocks are a share of ownership in a company and give the stockholder voting rights, while bonds are similar to lending a company or government money.
What is one main distinction between stocks and bonds quizlet? ›
One main distinction between stocks and bonds is that... Unlike stock dividends, a bond's interest does not go up and down.
What's the Difference Between a Share and a Stock? A stock is an equity instrument issued by a corporation that represents ownership of that company. A share is one unit of that ownership. You would say "I own 10 shares of Apple stock" for example.
What are the pros and cons of stocks? ›
Investing in stocks offers the potential for substantial returns, income through dividends and portfolio diversification. However, it also comes with risks, including market volatility, tax bills as well as the need for time and expertise.
How much stocks vs bonds? ›
If you add up the value of your investments, your portfolio may have 75% of its value in stocks, 20% in bonds, and 5% in cash. If you're committed to your allocation strategy, you can either put new investment money into bonds and cash equivalents, to bring the value of your overall holdings back into balance.
What is the difference between a bond and a stock? ›
Stocks vs. bonds. The biggest difference between stocks and bonds is that stocks give you a small portion of a company, whereas bonds let you loan a company or government money.
How do you compare stocks and bonds? ›
Bonds are typically safer than stocks, offering fixed interest payments and capital protection. Stocks, however, usually provide higher returns but come with greater risk. The choice depends on your risk tolerance and investment goals.
What is the difference between stocks and bonds which are considered safer Why? ›
In general, stocks are riskier than bonds, simply due to the fact that they offer no guaranteed returns to the investor, unlike bonds, which offer fairly reliable returns through coupon payments.
Do bonds pay interest or dividends? ›
A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value.
Are bonds a good investment? ›
Historically, bonds are less volatile than stocks.
Bond prices will fluctuate, but overall these investments are more stable, compared to other investments. “Bonds can bring stability, in part because their market prices have been more stable than stocks over long time periods,” says Alvarado.
What is a bond for dummies? ›
By buying a bond, you're giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year. Unlike stocks, bonds issued by companies give you no ownership rights.
