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In a nutshell
Bonds and stocks are often discussed in conjunction with one another, as though they are similar types of investments. They are different however, and the strengths of one can offset the weaknesses of the other, which is why many people invest in both at the same time.
- Stocks are shares of a company that confer rights of ownership over a portion of the company’s profits.
- Bonds are debt that companies, governments or other institutions sell to raise money.
- Stocks and bonds have different opportunities for profit and different risks that investors need to be aware of before investing.
Stocks vs. bonds: An overview
Here are some of the main differences between stocks and bonds.
| Feature | Stocks | Bonds |
|---|---|---|
Minimum investment | Price of one share of stock or fractional shares* | $100 for U.S. Treasury bonds, $1,000 for other bonds |
Issuer | Publicly traded companies | Public and private companies, governments, and government agencies |
What you’re buying | Equity in the issuing company | Debt securities of the issuing company or government body |
Financial benefits | Capital appreciation and sometimes dividends | Interest income |
Primary purpose | Capital growth | Capital preservation |
Available in funds (mutual funds, ETFs) | Yes | Yes |
*Fractional shares represent slices of whole shares, such as buying 1/50th of a $50 stock for $1.
Stocks: pros and cons
Pros:
- Potential for capital appreciation.
- Individual stocks and industry sectors often outperform the general market (sometimes by a wide margin).
- Some stocks also pay dividends, which can be considered income from stock ownership.
- Stocks generally outperform inflation.
- Can be purchased for as little as $1.
- Most investment brokers offer commission-free trading of stocks.
- The most popular stocks are highly liquid, which means they can be quickly and easily bought and sold.
Cons:
- You have the potential to lose your investment capital. Under extreme circ*mstances, the entire investment in a single stock can be lost.
- Creating and managing a portfolio of stocks requires above-average investment skills.
- Though stocks generally outperform other asset classes over the long term, they can experience extreme price swings in the short term.
Bonds: pros and cons
Pros:
- Bonds generally pay a fixed rate of interest at scheduled intervals.
- Protection of principal if bonds are held to maturity.
- Potential for capital appreciation if interest rates fall and securities are sold before maturity.
- Generally stable price levels in the short term.
- Bonds generally pay higher interest than bank investments.
Cons:
- Issuers sometimes default on bonds, rendering them worthless.
- The market value of a bond can decline substantially if the issuer falls on hard times or files for bankruptcy.
- Bonds can lose market value if interest rates rise after they are purchased, though the full face value will be paid if securities are held to maturity.
- Bonds underperform stocks over the long term.
- Inflation can reduce or eliminate the real rate of return on bonds.
How to buy exchange traded funds (ETFs) or stocks
Publicly traded companies issue stocks. Stocks are available for trading on stock exchanges, such as the New York Stock Exchange (NYSE) and the NASDAQ exchange. Stocks that are issued by companies based outside the U.S. trade on foreign stock exchanges. Some stocks are not traded on formal exchanges and are referred to as over-the-counter (OTC) stocks.
You can purchase individual stocks and build your portfolio. Alternatively, you can invest in funds that invest in stocks. One of the most popular types of funds are exchange-traded funds (ETFs). These funds were originally index-based, which means their performance is tied to an underlying index, such as the S&P 500, the Dow Jones Industrial Average, or the Russell 2000. But now you can buy any flavor of ETF, from index-tracking ETFs to actively managed ETFs to ETFs that hold alternative assets like Bitcoin.
Much like shares of individual stocks, shares of ETFs trade on major stock exchanges. They can usually be purchased for the price of a single share in the fund (or a fractional share). There are thousands of individual ETFs to invest in. Many specialize in specific niches, including technology, healthcare, consumer goods, energy, or various regional funds that focus on stocks in Japan, Europe, Latin America, and other regions of the world.
Other ETFs specialize in stocks based on market capitalization. These can include large-cap, mid-cap, small-cap, or even micro-cap stocks. This type of segmentation is due to the fact that certain market sectors outperform the general market at different times.
Both individual stocks and ETFs can be purchased through investment brokers, such as Ally Invest and Public. Both platforms allow you to open an account with zero balance in your account and buy and sell stocks and ETFs commission-free. You can even choose to hold a mix of both individual stocks and ETFs with either broker.
How to buy ETFs or bonds
Corporate bonds are usually available in minimum denominations of $1,000. However, it may be possible to purchase bonds in smaller denominations. The more friction-free way to buy corporate bonds with a small amount of capital is through an ETF that specializes in bonds. Because you can invest in an ETF for less than $1,000, you can get access to an entire portfolio of bonds by purchasing a single share in a bond ETF.
You can purchase bonds through the same investment brokers where you purchase stocks. However, unlike stocks, corporate bonds are not usually available commission-free. Most brokers charge a fee for both the purchase and sale of bonds. This will vary by broker, so you should shop around between brokers to identify the lowest commissions, especially if you plan to invest in bonds frequently.
You can also purchase U.S. Treasury bonds in denominations of $100. Although Treasury bonds can be purchased through investment brokers, you can also buy and hold them, commission-free, through TreasuryDirect. U.S. Treasury bonds are issued in terms of 20 or 30 years. You can also buy shorter-term securities from the Treasury. Treasury bills have durations of months or years; Treasury notes are for terms between 2 and 10 years.
If you do purchase individual corporate bonds, it’s important to be aware of their ratings. Major bond rating agencies, such as Moody’s and Standard & Poor’s, issue ratings both at the initial bond issue and during periodic reviews.
Here is a sample of bond ratings from Moody’s:
| Rating | Definition |
|---|---|
Aaa | Obligations rated Aaa are judged to be of the highest quality, subject to the lowest level of credit risk. |
Aa | Obligations rated Aa are judged to be of high quality and are subject to very low credit risk. |
A | Obligations rated A are judged to be upper-medium grade and are subject to low credit risk. |
Baa | Obligations rated Baa are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics. |
Ba | Obligations rated Ba are judged to be speculative and are subject to substantial credit risk. |
B | Obligations rated B are considered speculative and are subject to high credit risk. |
Caa | Obligations rated Caa are judged to be speculative of poor standing and are subject to very high credit risk. |
Ca | Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest. |
C | Obligations rated C are the lowest rated and are typically in default, with little prospect for recovery of principal or interest. |
The higher the bond rating, the lower the interest rate on the bond. This is because there is an inverse relationship between the quality of the bond and the rate that is paid. Stronger issues are those that are less likely to default, and they have lower interest rates. Conversely, weaker issues have higher interest rates to pay investors a premium for accepting the higher risk of default.
Interest rate risk
Another risk with bonds is changes in interest rates. Bonds have an inverse relationship with market interest rates. If the interest rate rises after a bond is purchased, the market value of the bond will decline, usually to a level that increases the yield to something closer to the prevailing rate.
However, if interest rates fall after the bond is purchased, the market value of the bond can increase to a level that lowers the yield to something approaching the prevailing rate. If this happens, the bond can be sold before maturity for a capital gain.
The remaining term of the bond has a material impact on interest rate risk. For example, if you purchase a newly issued 30-year bond at 4%, and the prevailing rate rises to 5%, the bond may fall in value by as much as 20%. Because the bond has decades before it matures, the impact of interest rate changes is great.
Conversely, if you purchase an existing 30-year bond with five years remaining until maturity, the impact on the market value of the bond will be minimal because the bond will pay out in a short time period.
The question of bond quality, combined with the risk of interest rate changes, convince some investors to invest in bonds through an ETF. Investing in individual bonds requires more expertise, though if you hold a high-quality bond to maturity, you will get your principal back plus the interest set at the original interest rate.
When should you invest in stocks and/or bonds?
Investment advisors commonly recommend holding both stocks and bonds in an investment portfolio to provide diversification. Bonds tend to maintain their value over the long term so that they act as a counterweight when stocks are declining. In addition, bonds generate interest income and add to the cash flow of a portfolio.
Since both asset classes are recommended, what matters most is the allocation of the portfolio
For younger investors in their 20s and 30s, holding a portfolio with a larger stock allocation is recommended. The exact advice may vary, but, in general, a higher allocation is recommended because the investor has decades to recover potential losses. In addition, a higher stock allocation is likely to produce a larger portfolio in the future than one dominated by bonds.
At the opposite end of the spectrum, older investors — particularly those at or near retirement — should consider larger bond allocations. An investor who is 55 years old (or older) might maintain a mix 60% stocks and 40% bonds. This mix will provide a more predictable income stream while reducing volatility during downturns.
Regardless of age, these allocations can be adjusted based on personal risk tolerance. A younger investor with a lower risk tolerance may prefer a higher bond allocation than is normally recommended for their age range. An older investor with a higher risk tolerance may prefer a larger allocation in stocks.
The AP Buyline roundup: Why you need both stocks and bonds in your portfolio
The question of bonds versus stocks isn’t an “either/or” situation. Rather, it’s a question of allocation within a portfolio. If you’re unsure what your allocation should be, take advantage of Vanguard’s Investor Questionnaire. It asks you a series of questions designed to assess your risk tolerance, time horizon, and investment objectives. From there, it will give you an indication of what kind of allocation your portfolio should have.
If you’re completely unsure how to balance the two asset classes, you can simply invest in ETFs. You can choose a stock ETF a bond ETF, or even a single ETF that combines the two.
AP Buyline’s content is created independently of The Associated Press newsroom. Our evaluations and opinions are not influenced by our advertising relationships, but we might earn commissions from our partners’ links in this content. Learn more about our policies and terms here.
