- A bond is a financial security that represents a creditorship arrangement with the issuing entity, while a stock is a financial security that represents an ownership interest in the issuing entity.
- A bond compensates an investor with interest income and a stock compensates an investor with the potential for dividend income and share price appreciation.
- While bonds are less risky than stocks, stocks offer higher return potential.
- Prudent investors generally invest in both stocks and bonds, embracing a strategic allocation strategy that optimizes the risk-return profile of their portfolios. In some cases, they incorporate other assets.
How Are Bonds and Stocks Different?
A bond is a financial security representing a loan made by a creditor (the bondholder) to a borrower (the issuer). Bonds are regularly issued by companies, sovereign governments, states and local municipalities to finance their operations and fund special projects.
A stock is a financial security representing an ownership interest, or equity stake, in a company. The equity is established on a per-share basis, and the stock owners are commonly referred to as shareholders or stockholders. When you buy a share of stock (or multiple shares), you acquire a proportionate claim on a company’s net assets and future earnings.
There are many types of stocks and bonds. This guide is focused on publicly traded bonds and stocks, which trade freely on highly regulated exchanges, such as the New York Stock Exchange and the Nasdaq. More specifically, this guide speaks to unsecured, fixed-rate bonds (as opposed to floating-rate bonds) and common stocks (as opposed to preferred stocks).
An unsecured bond, also referred to as a debenture, is not backed by collateral. It compensates bondholders with interest income and provides a general claim on the issuer’s assets in the event of a default. A share of common stock offers the owner voting rights on company matters and the possibility for dividend income and share price appreciation.
Bonds offer a priority claim on a company’s assets and more predictable cash flows than stocks. As a result, bonds are generally considered less risky than stocks. However, stocks usually offer investors higher return potential and tend to outperform bonds over the long run.
Although bonds have a reputation for being a safer investment than stocks, some bond types are riskier than others types. Read the article to understand the pros and cons of investing in bonds and risk factors to consider.
Are Bonds or Stocks a Better Investment?
Under the right circumstances, bonds offer a predictable stream of income and exhibit stability during times of economic distress. Stocks, on the other hand, can be very volatile, but they provide unparalleled growth potential and can help investors outpace inflation and accumulate wealth.
That said, a 100% allocation to either bonds or stocks is far from ideal for most investors. Usually, a combination of these assets is sensible.
This begs the question of how much of your money to allocate to bonds, and how much to allocate to stocks. The optimal strategy depends on your investment objectives and tolerance for risk – which is largely determined by your investing time horizon.
Generally, younger investors should hold a much greater proportion of stocks in their portfolio than bonds. However, as you age and your investing horizon shortens, it is wise to gradually increase the proportion allocated to bonds. The idea is to maximize the wealth accumulation power of stocks over the long term while using bonds to protect that wealth over the short term.
This process requires a diligent stance and active rebalancing to keep your asset allocations in line with your targets. This entails some work, but it can be avoided by working with a robo-advisor or a full-service financial advisor.
How Does the Trading of Stocks Differ From the Trading of Bonds?
You can invest in stocks and bonds via the primary market or the secondary market. The primary market is the forum where companies and government entities issue securities directly to investors in exchange for cash. The secondary market is the forum where investors trade previously issued securities with each other.
Most retail investors participate via the secondary market by working with a financial advisor or making trades directly through a self-service brokerage account. That said, secondary market participation does not always involve buying individual stocks and bonds.
In many cases, investors gain exposure to stocks and bonds via actively managed mutual funds and passively managed index funds and exchange-traded funds (ETFs). All these vehicles provide share-based ownership of an underlying basket of securities and make periodic dividend payments to shareholders.
Excluding consideration for a cash reserve, many investors gradually move from a 100% allocation to stocks (in their early- to mid-career) to a 60% allocation to stocks and a 40% allocation to bonds (as they embark on retirement). Others embrace more aggressive or conservative glide paths.
What Are the Pros and Cons of Bonds?
Bonds can provide investors with a safe way to generate a predictable stream of income while providing stability to an investment portfolio. However, some bonds are illiquid and can expose investors to significant credit risk and interest rate risk.
- Offer a predictable stream of fixed-rate income
- Investment grade instruments are usually very liquid and exhibit minimal credit risk
- Can help stabilize a portfolio holding stocks
- Vast universe of Treasury bonds, U.S. government agency bonds, municipal bonds, corporate bonds and international bonds provides ample opportunity to diversify
- Non-investment grade instruments can be illiquid and exhibit significant credit risk
- Can be sensitive to inflation and interest rate changes
- In rising interest rate environments, bonds do a poor job of stabilizing an investment portfolio
- Can be a bad investment for individuals with long time horizons and the ability to withstand stock market volatility
To capitalize on the advantages and mitigate the risks of investing in bonds, make sure your holdings are largely comprised of liquid, investment grade issues with moderate duration profiles. Some non-investment grade and long-duration bonds can be beneficial, but caution is warranted.
What Are the Pros and Cons of Stocks?
Most people invest in common stocks to improve their finances and accumulate wealth. Stocks are the preferred vehicles to achieve these goals because they can generate a return on investment (ROI) that far exceeds that available with bonds and alternative assets.
Generally, this is accomplished via a combination of dividend income and share price appreciation. However, not all stocks pay dividends, and many experience share price depreciation rather than appreciation.
The risk of share price depreciation is magnified over the near term when stocks tend to exhibit a very high degree of volatility. For this reason, stocks should always be viewed as long-term investments. Never put money into stocks if you may need to access it in the next five years. Many conservative financial advisors bump that guidepost to 10 years.
Beyond the potential financial benefits, common stocks also offer investors voting rights on governance matters. This is rarely the main focus for small retail investors but can be very important to institutional investors with a significant stake in ownership.
Mitigating the Risks of Investing in Stocks
In addition to maintaining a long-term perspective, investors can mitigate stock market volatility by embracing the concept of diversification. This means buying a variety of stocks in different industries and geographic regions, thereby establishing balanced economic exposure — which has been shown to improve long-term performance and minimize downside risk.
In the past, achieving an appropriate degree of diversification was burdensome and costly. Fortunately, it is now a simple and inexpensive process, thanks to the many low-cost index funds and exchange-traded funds (ETFs) available in the market.
Alternatives to Stocks and Bonds
Publicly traded common stocks and bonds are staples in most investment portfolios. However, many individuals seek to improve the risk-return profile of their portfolios by incorporating alternative investments, such as real estate, floating-rate bank loans, commodities, private equity and private credit.
Nevertheless, private equity and private credit are not available to everyone, largely because they tend to be illiquid, volatile and difficult to understand. To protect inexperienced investors, the Securities and Exchange Commission (SEC) only allows relatively wealthy and/or highly knowledgeable, accredited investors to buy these securities.
Frequently Asked Questions About Bonds and Stocks
A bond is a financial security that represents a loan made by an investor to a company or government entity. The loan is paid back on the specified maturity date of the bond. In the meantime, the investor typically receives fixed-rate interest payments on the loaned amount.
A stock is a financial security that represents an equity interest in a company. The equity is established on a per-share basis, which enables a company to grant multiple shareholders proportionate claims on its net assets and future earnings. Incidentally, shareholders also usually have the right to vote on governance-related matters.
You can lose money when investing in stocks and bonds. However, the downside potential is generally greater when investing in stocks, because bonds offer a priority claim on a company’s net assets and more predictable cash flows. That said, stocks usually offer investors higher return potential and tend to outperform bonds over the long run.
Rapidly rising interest rates tend to be bad for both stocks and bonds, and rapidly declining interest rates tend to be good. In moderate environments, stocks tend to fare better than bonds in rising-rate environments, while bonds tend to fare better than stocks in falling-rate environments. The contrast is greatest for bonds with relatively long durations.
Editor Malori Malone contributed to this article.