Stocks and bonds are the two most common types of investments in most portfolios. Both of these asset classes can build wealth and can also be less risky to invest in than some of the alternative assets you might hear or read about. But what sets them apart and which one should you focus on as an investor?
Should You Invest in Stock or Bonds?
You’re about to learn more about the differences between stocks and bonds, how they work and why they should be a pivotal part of your investment strategy to reach financial independence. There is a key difference between the two but it really depends on your investment objectives and even retirement goals. It’s important to understand your goals, whether short or long-term.
What’s the Difference Between Stocks and Bonds?
Stocks and bonds share the common goal of helping investors build wealth. But how each asset works, the potential losses and risks, and how each makes money is different.
Here is a quick bonds vs. stocks comparison:
- Bonds. Lend money to a company or government and earn a fixed income. Can also make money if selling bonds at a premium to the original purchase price.
- Stocks. Own a direct equity or ownership stake in the company and can make money when share prices increase, or dividend payments with preferred stock.
How Stocks Work
Stocks are an equity investment or sometimes referred to as equity securities. You earn a partial piece of the company and primarily make money when the stock price increases.
There are different types of stocks, with some stocks paying a dividend which is similar to earn savings account interest.
In general, the difference between stocks and bonds is that the risk of stock is higher than bonds because you’re buying an equity stake. If a company fails, stockholders are the last investors to receive payment for shares they try to sell.
Stock Investment Options
The compounding power of stocks make them a good option for younger people looking to achieve retirement goals. There are several ways you can invest in stocks in a taxable or retirement account.
- Individual shares: Buy shares of individual companies
- Stock funds: Buy mutual funds or ETFs that invest in multiple companies
- Options: One-way trades that can make money if share prices rise or fall
Within these investment choices are different-sized types of companies and fund investment strategies.
You can buy individual shares of high-risk “penny stocks,” go for more risk-averse blue-chip dividend stocks or many stocks somewhere in between. Having a good mix of stocks, and even a good mix of assets in general, in your investment portfolio is ideal.
Stock funds may track a single market index like the S&P 500 like index funds or try to outperform an index with an actively-managed fund.
Some funds invest in a specific sector like energy or semiconductors. These are called sector funds and are available as mutual funds or ETFs.
Other specialized stock funds invest in companies with a specific trait like a low carbon footprint or an emphasis on female leadership. These funds are sometimes called socially-conscious investments or environment, social and governance (ESG) funds).
Are Stocks Risky?
Any investment has some amount of risk, including an FDIC-insured savings account holding your emergency fund. Stocks are inherently riskier than bonds and bank-like investments but can also earn higher investment returns.
Here are some of the most common risks to stocks.
Declining Share Prices
Investors make money by investing in stocks when share prices increase. The classic mantra is to “buy low and sell high.”
Another option is to “buy high and sell higher.” Most investors buy individual stocks and stock funds with the intent of holding for multiple years and selling at a higher price.
The average historical return of the S&P 500 is approximately 8% per year. Most stocks can be sold for a profit when held long-term.
Several factors can cause share prices to decrease, including:
- Missing analyst estimates
- Corporate scandal
- Market recession or correction
- Company fails to develop new products
- An industry falls out of favor with investors
- Bankruptcy
Share prices may take several years or decades to be worth more than the original purchase price if a recession or corporate problem happens.
This uncertainty is why investors tend to invest in more bonds as they approach retirement age and shift from a capital appreciation strategy to wealth preservation. The potential investment income is lower but so is the risk level.
Dividend Suspension
Stocks with financial trouble may reduce or suspend dividend payments. In addition to losing recurring income, share prices may tumble as investors only holding the stock for the dividend income sell shares and shift to another dividend stock.
Stock Market Correction
A broad market selloff causes nearly every stock, including high-quality stocks, to decrease in value. Investors sell investments out of fear or because they need the cash.
Share prices can rebound when the correction ends and a bull market resumes.
How Bonds Work
Bonds are a debt investment and make money when the borrower makes interest payments. This means that bondholders receive regular interest payments on their invesments.
Bond investors lend money to businesses and governments but don’t own a stake in the company. While you don’t directly invest in the company, bond investors can receive compensation before stock shareholders if a company fails, which is why bons are generally considered one of the safer investments.
Several different metrics make up a bond:
- Bond prices: The initial investment cost to purchase bond shares
- Face value: The price the bond will be worth at maturity
- Bond yields: The investment rate of return (the yield rate fluctuates with the bond price)
- Maturity: When the bond investment period ends and you can sell your shares
- Duration: Sensitivity to interest rate changes
- Credit risk: Risk rating to help determine the investment risk
Bond index funds are the most realistic way for most investors to invest in bonds as funds have lower investment minimums. Investing in individual bonds usually requires a high investment of several thousand dollars.
The high investment minimums are a stark contrast to investing in stocks. Several online brokers let you buy fractional shares of stocks with a $5 minimum investment.
The high growth potential and easy accessibility are why more investors are familiar with stocks than bonds. However, with growth investing comes a higher level of risk than value investing (bonds).
Bond Investment Options
There are several different types of bonds available to bond investors through online brokers that also offer stocks:
- Corporate bonds: Investment-grade bonds for large corporations
- Government bonds: National, state and municipal bonds (government)
- Treasury bonds: Bonds issued by the US Treasury
- High-yield bonds: “Junk” bonds for high-risk companies
- Mortgage-backed bonds: Bonds that use mortgages as collateral
- Bond funds: Mutual funds and ETFs that invest in corporate and government bonds
- Certificates of deposit: Lend money to a bank for a fixed investment period
Most bond investments are corporate, government and US Treasury bonds. These bonds are easier to invest in because of the higher borrowing amounts and they are less risky than small business bonds.
It’s possible to invest in individual bonds, but the investment minimums are high and you need to use a traditional online broker.
Many investors invest in bonds through bond index funds and actively managed funds. The fund manager automatically rebalances the portfolio to continue holding bonds with the target maturity date.
For example, the iShares 20+ Year Treasury Bond ETF (TLT) holds US Treasury bonds with a minimum 20-year maturity date.
Are Bonds Risky?
Most bonds are less risky than stocks because they are a fixed income investment that pledges to return a regular interest payment. Investors can estimate the total potential investment gains upfront.
Bonds have several risk factors to consider.
Inflation
Bonds earn fixed income but the yield may be lower than the inflation rate. Investors make investment income, but their money loses value as living expense increase.
The historical annual rate of inflation is approximately 3%. Bonds and other fixed income investments with an annual rate of return below the inflation rate technically “lose money.”
Rising Interest Rates
Increasing future interest rates can also add investment risks to existing bonds. Investors can potentially make more by reinvesting their cash in new bonds or certificates of deposits with a higher interest rate and a shorter maturity date.
Bonds with a low duration rate are less affected by rising rates. Another strategy is investing in short-duration bonds with a maturity date of three years or less. As interest rates rise and the existing bonds mature, the cash can reinvest in new bonds with higher potential yields.
Credit Default
Companies and governments can default on their bond payments. Investors lose the interest income and may also lose the initial investment if there isn’t sufficient collateral to offset the outstanding debts.
Investors should consider investment-grade corporate and government bonds. Investment-grade bonds have a minimum “BBB” rating and can be as high as AAA.
Borrowers with an investment-grade rating are less likely to default but may also have a lower yield than “junk” bonds with a rating below “BBB.”
Stocks vs Bonds: Which Investment Earns More?
Do stocks or bonds make more money for investors?
Most investors get exposure to stocks and bonds using broad market index funds due to the low investment costs and the ease of access.
Here is a quick comparison of two stock and bond index funds that give investors exposure to almost every publicly-traded stock and bond investment.
| Stocks returns vs. Bonds | |||
| ETF | Initial Investment (February 2011) | 10 Years Later (as of Feb 28, 2021) | Total Rate of Return |
| Vanguard Total Stock Market ETF (VTI) | $10,000 | $35,330.70 | 253.31% |
| Vanguard Total Stock Market ETF (BND) | $10,000 | $14,138.40 | 41.38% |
*These calculations were generated using Vanguard. The performance details are current as of 02/28/2021 for a hypothetical $10,000 investment for ten years (February 2011 to 2021).
Stocks have been the better investment for the past decade as most stock markets have been in a bull market. However, bonds have less downside risk and may lose less money during a recession.
Multiple underlying factors impact stock and bond returns including the market conditions and the quality of the holdings.
Large Cap Stocks are Less Risky Than Small Caps
Large cap stocks like Apple, Microsoft or Walmart that are well-known and trade in the S&P 500 tend to be less volatile than smaller companies with more growth potential but are still risky.
Bonds are Less Risky Than Stocks
Most bonds are inherently less risky than stocks because investors can earn fixed interest payments until the note matures. If a company goes bankrupt, bond investors receive payment before stock investors because it’s a debt investment.
Stocks rely on appreciating share prices to make money but don’t earn a fixed income.
Many stocks pay a dividend, but companies can suspend dividend payments without notice. Investors can still “lose money” if the dividend payments are smaller than a share price drop.
Funds Are Less Risky Than Individual Stocks and Bonds
Investing in stock and bond funds can be less risky than investing in individual stocks or bonds because of the additional diversification. You get exposure to hundreds or thousands of companies with the same investment instead of only investing in a few company stocks.
How to Invest in Stocks and Bonds
Here are some simple ways to invest in stocks and bonds.
Index Funds
Stock and bond index funds are the easiest and most cost-effective way to invest in stocks and bonds. Some funds are “total market” funds that track the entire stock or bond market’s movement.
Others focus on a specific stock or bond sector like small cap stocks or international bonds.
Target Date Retirement Funds
Many brokers offer target date retirement funds. Investors can choose a target date fund that’s nearest their planned retirement date. The fund manager gradually shifts to holding more bonds as the retirement date approaches to minimize risk.
Employer-Sponsored Retirement Plans
Your 401(k) or a similar plan likely offers stock and bond funds. Some options are passive index funds that mimic a specific market and others are active funds trying to “beat the market.”
Retirement plans may also offer target date funds or an automated portfolio allocation tool. These options can be a smart money move as you can effortlessly invest in stocks and bonds and let the experts rebalance your portfolio.
Robo-Advisors
Another popular investment trend is using a robo-advisor. These fully-automated investment platforms recommend a stock and bond asset allocation using your age, investment goals and risk tolerance.
The robo-advisor charges an annual advisory fee but automatically rebalances your portfolio. Your portfolio automatically sells stocks and buys bonds as your planned withdrawal date draws closer.
Stock and Bond Asset Allocation
Most investors will invest in stocks and bonds at the same time. Holding both lets you enjoy stocks’ upside potential during a bull market along with the fixed income and low volatility of bonds to reduce investment risk.
Young investors in their early 20s may decide only to hold stocks if they have decades until retirement. If a market correction happens, they can wait several years for stock values to return to their pre-correction levels and still have a higher net worth than only holding bonds.
Retirees may hold mostly or entirely bonds to avoid losing money in retirement. The fixed income payments can help cover monthly expenses to avoid selling assets.
Knowing how much to invest in stocks and bonds can be a somewhat difficult decision to make.
Some financial advisors recommend the “120 Rule” by subtracting your current age from 120 to determine your stock and bond asset allocation.
For example, 120 minus 35 years equals a recommended asset allocation of 85% stocks and 15% bonds.
Here is the sample asset allocation by age following this rule:
- 20 years old: 100% stocks/0% bonds
- 30 years old: 90% stocks/10% bonds
- 40 years old: 80% stocks/20% bonds
- 50 years old: 70% stocks/30% bonds
- 60 years old: 60% stocks/40% bonds
- 70 years old: 50% stocks/50% bonds
Your investment strategy is personal and the above asset allocation models are a recommendation. But this strategy can be a good starting point to find an age-appropriate risk tolerance.
Investing in Stocks Pros and Cons
Below are the positives and negatives to investing in stocks.
Pros
- More long-term growth potential than bonds
- Stocks can be easier and cheaper to buy than bonds
- Can earn dividend income
Cons
- More volatile than bonds
- May not earn a dividend
- Need rising share prices to make positive capital gains
Investing in Bonds Pros and Cons
Here are the reasons to consider investing in bonds.
Pros
- Earn fixed income
- Less volatile than stocks
- Corporate and government bonds are available
- Receive compensation before stock investors during credit default
Cons
- Less long-term-growth than stocks
- Expensive to buy individual bonds (buy bond funds instead)
- Yields may be lower than the inflation rate
Final Thoughts on Stocks vs. Bonds
Stocks and bonds are an essential part of most investment portfolios. Younger investors can handle the risk and should consider holding more stocks as they have more growth potential.
Having a stock portfolio of long-term value stocks would be less risky than the more volatile growth stocks you may read about on social media, but it could be worth testing the waters with both if you feel the desire and can deal with the risks.
Those near or fully-retired should favor bonds due to their increased stability and fixed income. But safely building up your retirement portfolios with both stocks and bonds can create reliable income down the road.
