A Guide to Stocks vs. Bonds
By: Idaho Trust Bank Staff
A Guide to Stocks vs. Bonds
Stocks and bonds are two common types of investments that are likely familiar to you in name at the absolute least. If you are new to investing, however, you may not be familiar with them beyond that.
Before we get into what makes each unique, the first major things to know about stocks and bonds are:
- Both stocks and bonds are types of investments.
- The primary differences between the two are how they generate profit and what they represent.
Stocks and bonds are important investments for diversifying your portfolio. However, deciding which investments are right for you and your portfolio can be a daunting task, especially when you don’t have prior investing experience. Fortunately, however, you don’t have to go into this process blind or on your own; you can talk to a financial expert with an investment approach that emphasizes your personal needs.
Not only will you be able to feel more confident your money is being used to its fullest potential right now, but you can also discuss your long-term plans and financial goals with an investment manager.
Now, before you take the big leap into investing with stocks and bonds, let’s take a look at what makes each unique.
No doubt you’ve heard of stocks and the stock market. Maybe you’ve seen stock prices on the nightly news or on apps that come installed on your smartphone, so let’s take a deeper look at what makes them a unique type of investment.
What Are Stocks?
According to the U.S. Securities and Exchange Commission, “Stocks are a type of security that gives stockholders a share of ownership in a company. Stocks also are called ‘equities.’”
As mentioned earlier, the primary differences between stocks and bonds are how they generate profit and what they represent. Let’s take a look at both of those ideas
What do stocks represent?
Stocks represent partial ownership in a company.
When you buy stock in a company, you are buying a small sliver of that company. Buy a stock? Congratulations, you’re a business owner (of sorts)! Therefore, the more stock, or “share” in one company that you buy, the greater portion of the company you own.
How do stocks generate profit?
Stocks generate profit by appreciating in value and then being sold on the stock market.
To generate a profit, the investor must sell stocks at a price that is higher than the original purchase price. Therefore, stocks are not guaranteed to generate profit and can potentially lose money for the stockholder if they sell them for a lower price than the original purchase price. Prices are determined by the supply and demand of stocks as investors buy and sell shares through a public marketplace.
Different Types of Stock Options
There are two major types of stocks: common and preferred.
- What are common stocks? Common stocks entitle stockholders to voting privileges at shareholder meetings and allow them to receive dividends.
- What are preferred stocks? Preferred stocks typically do not entitle stockholders to voting privileges at shareholder meetings. However, preferred stockholders do receive dividend payments before common stockholders and receive priority in a situation where the company’s assets are liquidated due to bankruptcy.
Common and preferred stocks can also be categorized into more specific subcategories. Here are some of the most common stock subcategories you will likely hear about when stocks are discussed:
- Value stocks: Cheaper to buy than other stocks due to a low price-to-earnings ratio (PE) from being a growth or income stock, or potentially due to investors’ negative perceptions.
- Penny stocks: The lowest-priced stocks from companies with very little earnings. These are highly speculative and do not pay out dividends.
- Growth stocks: Earnings are growing at a faster rate than the market average; these rarely pay dividends. Bought by investors in hopes of capital appreciation.
- Income stocks: Named for the consistent dividends and income they generate for investors.
- Blue-chip stocks: Shares in sizable and well-known companies with a consistently solid track record of growth; these usually pay dividends.
Why Invest in Stocks?
There are certainly many reasons to invest in stocks. Like all investments, however, there are also associated risks that you need to be aware of.
Reasons stocks can be a wise investment:
- Stocks have greater average returns than bonds.
- Through diversifying stock investments across many different companies, investors typically can mitigate the greater level of risk associated with stocks over other forms of investment.
- The S&P 500 Index, which charts the 500 largest companies on the U.S. stock market, has an average annual return of around 14% compared to the 7% return of bonds on the Bloomberg U.S. Aggregate Bond Index.
- Equity allows for future growth opportunities.
Risks associated with stock investments:
- Prices of stocks can fluctuate greatly.
- The unpredictable nature of stocks means that it is highly likely that a stockholder will not see the greatest potential return on their initial investment.
While they’re still a common form of investment, bonds are not nearly as well known or understood as stocks. Let’s take a look at bonds and what differentiates them from stocks and other types of investment.
What Are Bonds?
According to the SEC, “A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time.”
What do bonds represent?
Bonds represent debt that a company sells to the bondholder with the promise to pay back the debt with interest.
Bonds are a loan you make to either a company or government that promises to pay you back for that loan plus interest accrued. In this way, bonds are a much more straightforward investment than stocks are since there is no change in value or selling of the investment required to generate profit.
How do bonds generate profit?
Most bonds generate profit by paying fixed interest over time.
This makes bonds much more predictable and steady in their returns than stocks or many other types of investment. However, this consistency typically comes at the cost of greater potential returns that the investor may realize through stocks and other investments.
Types of Bonds
There are three major types of bonds: corporate bonds, high-yield bonds, and municipal bonds.
- Corporate bonds: Debt securities issued by private and public corporations.
- High-yield bonds: A greater risk, greater reward type of bond with a lower credit rating (greater risk), but offering higher interest rates in return (greater reward). As opposed to “investment-grade” bonds, which have a higher credit rating with generally far less risk.
- Municipal bonds: Debt securities issued by states, cities, counties, and other government entities. Also referred to as “munis,” there are several types of municipal bonds, including:
- General obligation bonds: Not secured by any assets, but are instead backed by the reputation and standing of the bond issuer.
- Revenue bonds: Backed by revenue from a particular source of money such as a government project or various revenue streams instead of taxes.
- Conduit bonds: Issued by a government on behalf of a private entity such as a university or hospital.
Why Invest in Bonds?
Now that we’ve discussed what bonds are and the wide variety of bond types, it’s time to look at why someone would be wise to choose bonds as a form of investment as well as the common risks associated with bonds as an investment.
Reasons bonds can be a wise investment:
- Potential for capital gains.
- Consistent interest payments are a reliable source of income. This makes bonds especially great options for funding things such as retirement accounts.
- May have lower risk than stocks and other forms of investment.
Risks associated with bond investments:
- If the issuer fails to make interest or principal payments they may default on the bond.
- Changing interest rates can affect a bond’s value.
- Inflation can devalue a bond over its lifetime.
- If there is not a market for the bond, then investors may not be able to buy or sell bonds how they wish to.
Which Investment Is Right for You: Stocks or Bonds?
So, which is right for you, stocks or bonds? Unfortunately, the answer to this question isn’t a simple one. It depends upon your personal and financial situation.
Here are a few questions to ask yourself to determine if stocks or bonds are better for your situation:
- Do I prefer greater risk with chances of greater reward, or a more conservative yet consistent return on my investment?
- How much return on my investment am I looking to receive and after how much time?
- Do I have specific goals in mind that I am looking to achieve by making this investment? If so, what are they?
Sometimes, a person may have further questions that pertain to their custom financial goals. Speaking to a representative from a trusted financial institution can get you the answers to these questions. You can also discuss further services they provide to help your money go even further, such as wealth planning* to ensure your long-term financial security.
One final consideration you might need to make in terms of your investments is that stocks and bonds may potentially come up as assets to be distributed to your family and loved ones as part of a trust. It is important that you speak with a trust and estate expert* so that your investments continue to bring returns even after you are gone.
*Not a deposit or other obligation of, or guaranteed by, the bank or an affiliate of the bank; Not insured by FDIC or any other agency of the United States, the bank, or any affiliate of the bank; May lose value.