In the investment world, stocks are the life of the party. Bonds are boring to be honest.
Even if you’re a set-it-and-forget-it investor, just watching stocks can be exciting. Last year the stock market brought us wild stories about GameStop, Tesla and newly shaped day traders. But who the hell starts a conversation by talking about what the bond market was doing today?
Stocks are certainly the more interesting capital, but when it comes to investing, it pays to be at least a little boring. Here’s an introduction to stocks and bonds – and why you need to own both.
What is a share?
If a company wants to grow, it will often go public. That means his shares will become available in the open market to investors like you and me. When you buy shares in a company, you become the owner of a tiny part of the company. There are two ways to make money from stocks:
- The share price goes up and you sell it for a profit. You would think this is happening because the company is profitable. But sometimes the price of a stock skyrockets even though the issuing company is losing money. Or it will go down even though the company is doing well. This is because stock prices contain predictions from investors rather than current reality. Tesla, for example, lost money almost every quarter from its 2010 IPO through 2018, but its shares still rose 1,340% over that period.
- The stock pays a dividend. Sometimes companies distribute part of their profits to shareholders by paying a dividend. You are more likely to receive a dividend from blue chip stocks issued by large companies with long histories of stable profits. Think of Johnson & Johnsons and Procter and Gambles of the world. A company that is in startup mode needs to reinvest its profits so it is less likely to pay dividends to shareholders.
There is no limit to how much a company can make, which means that in theory, your potential earnings from stocks are also unlimited. You could become a millionaire by choosing the nearest Apple or Amazon. Or you could lose all of your investment if a company goes out of business.
While stocks are often described as a risky investment, this is an over-simplification. Investing in blue chip stocks is a far cry from investing in penny stocks, which are usually super cheap because the company behind them is unprofitable or financially in trouble. You can further reduce your risk by investing in index funds, which you automatically invest in hundreds or even thousands of companies. This protects you from the risk of business failure.
Investing in stocks is usually the way you grow your money and build a nest egg. While the stock market can be volatile, you shouldn’t be afraid of short-term losses. Long term growth is what you are looking for.
What is a bond?
Often times, when a government or corporation needs to fund debt, they issue bonds. When you invest in bonds, you become a believer. You will get paid as long as the company or government does not default on payments. There are three main types of bonds:
- US Treasuries, issued by the federal government. They are considered to be the safest investment on the planet as the risk of the U.S. government failing to pay its debts is essentially zero.
- Municipal bonds, issued by state or local governments. They are a bit riskier than US Treasuries, but are still considered a safe investment.
- Corporate bonds, issued by companies. They differ in terms of risk. The safest corporate bonds are often referred to as investment grade bonds. The riskiest ones are known as junk bonds.
Most bonds offer fixed payments called coupons, which are usually delivered twice a year. When the bond has reached its maturity, i.e. the loan end date, you will also be paid back on your principal.
So if you bought a bond for $ 10,000 that paid 5% interest for five years, you will receive interest payments totaling $ 500 per year for five years. At the end of five years, you would get your $ 10,000 back.
Bonds don’t have the kingmaker potential that stocks do. If you’ve bought bonds from Apple or Amazon that pay 3% annually, you get 3% annually regardless of how much the company profits or how much its stock prices rise.
Bonds are generally safer than stocks. But that is also a simplification. Like stocks, bonds are subject to risk.
U.S. Treasuries are backed by the federal government, so you’re essentially guaranteed to get paid back. The disadvantage is that you get extremely low interest payments because you are hardly taking any risk.
A 10 year Treasury bill currently yields 1.18%. Your real risk is that interest payments will not keep pace with inflation, which is essentially the equivalent of losing money. Your money will buy less and less over time.
However, some bonds can be very risky. In comparison, a junk bond issued by a troubled company can generate a return of 6% or more for the same reason you would pay a higher interest rate if you had poor credit: the lender has to pay for one additional risk will be compensated. Just like with stocks, investing in a single bond can be dangerous. When you invest in a bond index fund that works much like a stock index fund, you get a diversified portfolio.
Showdown Between Stocks and Bonds: 5 Key Differences You Should Know About
Now that we’ve covered the basics of stocks and bonds, let’s summarize five key differences that will matter to you as an investor.
1. Stocks offer unlimited potential returns, while bonds offer fixed income securities.
The price of a stock could technically rise infinitely, so your potential gains are unlimited. To make money from stocks, you must either sell them for a profit or receive a dividend – but returns and dividends are never guaranteed.
The advantage of bonds is that the issuer is contractually obliged to make interest payments. This fixed income is especially valuable if you have an old-age budget. While you could also make money buying and selling bonds, it is risky for most people. Stability rather than high returns is usually why you invest in bonds.
Realistically, you can expect an average annual return of around 10% if you’ve invested in S&P 500 index funds.
2. Corporations and governments issue bonds, but only corporations issue stocks.
Both companies and governments issue bonds to finance debt. Only companies issue stocks. They do this by going public through an IPO and making their shares available in the open market. Typically, companies do this to raise funds to fuel their growth.
3. Stocks are more volatile than bonds, which means that their prices fluctuate more.
Still, if you are a decade or more away from retirement, that shouldn’t worry you. Your money has time to recover if the stock market crashes. If you invest in the stock market and have invested your money for at least a decade, your returns will be positive more than 90% of the time.
4. Shareholders are paid after bondholders when a company files for bankruptcy.
Secured creditors like a bank holding a mortgage must be paid first when a company files for bankruptcy. Once all of these claims have been paid, it is the bondholders’ turn. But the shareholders are the last in line. After bankruptcy, equity investors are often left with nothing.
5. It is popular belief that stock prices and bond prices move in opposite directions.
It is believed that investors will seek the safety of bonds in the stock market tanks, while investors will take money out of bonds when stocks go up for higher returns. In recent years, however, stock and bond prices have not always moved the other way around. For example, during the COVID-19 panic in March, both stock and bond prices plummeted.
Typically, you want to start investing primarily in stocks and then invest more money in bonds as you get older. The reason for this is that when you are younger and have decades left to retire, you want your money to increase. You also have plenty of time to recover from a stock market crash. But the closer you get to retirement, the more vulnerable you are to a bear market. So you want safer investments.
Bonds versus Stocks: What’s the Right Mixture?
One way to ensure that your asset allocation is correct is to invest your retirement assets in a fund with a cut-off date. It will gradually rebalance your mix of stocks and bonds as you near retirement.
Another option is to use a robo-advisor to choose the best mix of assets based on your age, age goals, and risk tolerance. This is much more likely to be an option if you have a Roth IRA or a traditional IRA than a 401 (k) plan or other employer-sponsored account.
When you’re determined to shape your own asset allocation, financial planners often recommend the following rule of thumb: Your proper stock allocation is 110 minus your age. So when you are 40 you want 70% stocks and 30% bonds.
Whichever mix of assets you choose, it’s important to start investing right away. Time is the best weapon for making money grow.
Robin Hartill is a certified financial planner and senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advisory column. Send your tricky money questions to [email protected].