Stocks and bonds: What’s the difference?
Stocks: Own a piece of a company
Holding stock in a company means you own a small piece of it, called a share. Your returns as a shareholder are tied to the company’s success. The value of your investment will rise and fall along with the company’s profits and setbacks.
Investing in stocks can be stressful at times. You buy stock hoping it will rise in value, but prices can rise and fall significantly from day to day.
Sometimes prices move based on rumors or gossip, other times because of problems with the company’s management or due to strong competition. If a company goes out of business, the stock can lose its value completely. This is why most investors choose to own more than one stock or spread their investment over hundreds of companies through a stock mutual fund.
Bonds: Lend your money with interest
When corporations or governments need money, they can borrow from investors by selling bonds. Instead of buying a share of stock, you’re making a loan. A company could use the money to finance an expansion, for example. A government entity could fund a public project.
Each bond has a set term, during which you are paid regular interest (the yield). This is why bonds are known as fixed-income investments. At the end of the term, you get back the money you initially invested, which is your principal.
While the payments and return of principal aren’t necessarily guaranteed, bonds are considered to be more stable investments than stocks. That’s because their prices typically fluctuate less. They may also provide some regular income. Not all bonds are equal, however. Some bonds carry more risk than others, but investors are usually compensated for that extra risk by potentially earning higher yields.
Defaults are less frequent than with stocks, so there’s less risk involved. But the returns are generally lower too. Buying individual bonds can be complicated, but a bond mutual fund can give you exposure to many different bonds at once.
Diversification: Strike a balance
Given their uncertainty, stocks may not be the best place to invest money you’ll need right away. However, stocks have provided higher returns over longer periods of time. If you plan to be invested for at least 10 years, stocks can offer more potential for growth. If you need the money in the near term, bonds may be the more conservative choice.
Your financial plan may have both stocks and bonds. How you balance the two assets is just one step toward having a diversified portfolio, which can help reduce your overall risk as an investor.