Updated August 6, 2019

Difference Between Stocks and Bonds

Read more about Investing

Stocks are riskier with potentially higher returns, while bonds are more predictable. A good investment strategy includes a mix of both. Read on to learn more.

Stocks and Bonds

You do not need a degree in finance to understand investing. But it does help to understand the difference between stocks and bonds.

In this article, we help you break down the differences. We also help you understand where and when you should invest in each. You can take the concepts as they apply to your life and start your investment portfolio.

What is a stock vs a bond? Stocks represent ownership in a company. When you buy a share, you're buying a little piece of the company. Bonds represents a company's debt. When you purchase a bond, you become a lender to the company. Bonds have a fixed interest rate and maturity date.

Do You Want Ownership or Debt?

Breaking stocks and bonds down is as easy as understanding the difference between ownership and debt.

Purchasing a company's stock helps the company get the cash they need to build their business. Offering shares allows businesses to avoid taking on new debt. They receive cash in exchange for the shares. They then use the cash to help their business flourish. When you buy a share, you own a "piece" of the company. The shares may go up or down in value.

You want to invest in stocks only when you are in it for the long run. You need the time to wait out the downturns the stock may take. The price of the shares fluctuates based on the company's performance. Companies doing poorly have plummeting stocks while those doing well have rising stock prices.

Stocks are not a debt - the company does not owe you anything for the purchase. Instead, you receive a piece of the company in return; you could even receive voting rights.

Bonds are a company's debt. You become the "lender" to the company. When you purchase a bond, the company takes the cash for operations or building it up. In exchange, you receive a bond. The bond has a specific interest rate and maturity date. The company must pay you the appropriate amount by the maturity date. Bonds have specific terms to understand:

  • Face value - The amount you pay for the bond.

  • Coupon rate - The interest rate the company agrees to pay you.

  • Maturity - The length of time the company has to pay back the face value of the loan.

Here is a simple example:

You buy a bond for $1,500; this is the face value. It has a coupon rate of 2% and matures in 5 years. For the next five years you would receive $30 in interest each year. If you have a semi-annual coupon rate, you would receive $15 twice per year. After five years, you would receive the face value of $1,500 back from the company.

Equation You Can Use: Determine the return on your bond investment: Face value x Coupon rate = Annual return on investment

Bonds are predictable. You can calculate the return on your investment before you purchase one. Stocks, on the other hand, are volatile with no chance for prediction.

What is the difference between stocks, bonds, and mutual funds? Mutual funds are professionally managed portfolios of different stocks and bonds. You pool your money with other investors to purchase securities. You can get a diversified portfolio more easily than buying individual stocks and bonds.

Stocks Are Volatile

Stocks depend on many factors, including the company's performance and supply and demand for the stock.

  • Stocks in high demand have higher prices.

  • Stocks lower in demand have lower prices.

Investors figure in their thoughts and feelings on a company's performance at any given time as well. These factors add up to create the fluctuating stock prices.

Buying stocks means you make money when the company performs well. It also means you lose money when the company performs poorly. It is not as black and white as it seems, though. Many factors influence a stock price. For example, if there was a large recall on a company's products, chances are its stock plummets temporarily. A few weeks or months later, however, it could pick up again.

Stocks and bonds are different asset classes with different objectives. Select based on your objectives.

Note that the bigger question is how to protect your capital from the hidden enemy—inflation, which reduces the value of your investments. Most folks forget about this important element of investing.

Michael Osteen, founder and chief investment strategist, Port Wren Capital LLC

Waiting out a stock's ups and downs usually results in a larger return than bonds offer. Investing in stocks should be a long-term investment. This way you can ride out the ups and downs and hopefully come out on top.

Are stocks a riskier investment than bonds? Stocks are considered to be riskier because they are more unpredictable.

The performance of stocks depends on how the company is doing and the supply and demand, so the price can fluctuate more. However, historically, stocks have higher returns over the long-term.

Bonds Carry Risk

Bonds are not without risk either, though.

  • If interest rates fall, bonds suffer.

  • When interest rates increase, bond prices fall. Bonds then trade at a discount to accommodate the lower return.

Other risks bonds pose include:

  • Reinvestment Risk - If interest rates fall and the bond is called (i.e., redeemed prior to its maturity date), you run the risk of reinvesting that money at a lower rate than what you had on that bond.

  • Call Risk - Certain bonds have a "call provision." This allows the issuer to pay the bond off prematurely. Issuers typically do this when interest rates fall. The issuer pays the debt off and sells it to a new investor at the lower interest rate.

  • Interest Rate Risk - If interest rates rise, any bonds you currently own lose value (for example, if you own a bond with a 3% interest rate and rates increase to 5%). A new investor can purchase a bond at 5%. Selling your 3% bond will be difficult, causing its value to fall.

Tip: Short-term bonds offer a simple way to save money while securing a small return on the investment. Investing a portion of your emergency fund in 2- to 5-year short-term bonds can help you make more money. The return will be small, but it may be higher than the interest that savings accounts offer.

Keep in mind that bonds typically trade on the secondary market. You do not purchase them straight from the issuer. Instead, you purchase them from someone selling the bonds on the secondary market. When bonds sell in the market, they usually sell at a discount. The changing interest rates we discussed above affect a bond's value. This affects how much they sell for in the market.

In easy-to-understand terms, if the current interest rates exceed the bond's coupon value, it sells at a discount.

Keep in mind: Corporate bonds depend on the ability of the issuing corporation's ability to repay the principal on the bond (and the ongoing interest). If the company defaults or goes bankrupt, you lose your investment.

Asset Allocation or Diversification

A smart investor diversifies his portfolio. He also has a strategy to further his savings. Every investor's portfolio will look different, though. There is no right way for everyone.

Bonds provide you with a "lower risk" investment. You know your rate of return if you keep the bond. However, selling it on the secondary market may require you to sell for a discount. Stocks have an even higher risk. If you need your money, you have to sell at the current market price. You cannot predict what the market value will be at any given time.

You likely heard the term "don't put all your eggs in one basket." In investing terms, this means do not put all your money in one stock.

If you invest in the stock market, choose several stocks. You can use an index, such as the S&P 500, to help guide you to the larger and more stable stocks. Again, you cannot predict how any stock will do, so even a stock on the S&P 500 can plummet unexpectedly. If you put your money into different stocks, though, you may lose money on one stock, but make it back on another one.

If you want a solid investment strategy, you need a solid risk management system. However, understand you cannot ever escape risk. History can repeat itself and every asset across the board can plummet unexpectedly. Investing in high and low risk investments all at once minimizes the overall risk of your portfolio.

Do bonds go up when stocks go down? This is generally true. Stocks go up when the economy is doing well. When the economy isn't doing well, investors usually pull out of stocks (causing stock prices to fall) and invest in bonds instead (which causes bonds prices to go up).

What Is Your Timeframe?

Figuring out your timeframe will help determine the right investment strategy for you.

For example, a 30-year-old has a much different investment strategy than a 60-year-old. The 30-year-old still has many more years before retirement. He can handle more risks than a 60-year-old who may need his money for daily living right now. A 30-year-old who loses it all still has time to make it back. If a 60-year-old lost it all, it could financially devastate him.

Stocks tend to pay out more on average (7% per year, inflation adjusted, over the past 50 years on S&P 500) than bonds (1.8% per year, inflation adjusted), but stocks bounce around a lot. You only need bonds when you have a plan to grab the money soon or if you think stocks are going to drop very soon. Otherwise you should own mostly stocks. If the person is risk averse, or just cares about their time, they could buy a stock index fund.

Leif Kristjansen, blogger, FiveYearFIREescape.com

Generally, at age 50, taking fewer risks with your money is the better choice. This does not mean you have to stick to bonds and savings accounts at age 50. You need to change your investment strategy instead. Let's say you invested 70% of your money in stocks and 30% in bonds and money markets. At age 50, you may want to decrease the money you invest in stocks and increase the money in bonds.

Equation You Can Use:

Here is a simple equation to use as a guideline to help you figure out your asset allocation:

Men: 110 - your age = Percentage of your funds you should invest in stocks
Women: 120 - your age = Percentage of your funds you should invest in stocks

Men and women have different ratios because women have a higher life expectancy. This gives them a little more time to invest in "risky investments."

If you take a 40-year-old man and woman, it would look like this:

Men: 110 - 40 = 70% of a portfolio invested in stocks
Women: 120 - 40 = 80% of a portfolio invested in stocks

This pertains to investors with a long-term strategy. Before you determine the right asset allocation for you, determine your long-term goals.

What are you investing for? Is it for retirement in 30 years or to purchase a house in 5 years? Each situation has a very different investment strategy. A person with a very long-term goal (20 years) can invest in stocks without too much risk. Someone with a shorter goal (5-10 years) should diversify more, including bonds and stock market investments. If you have an immediate need for the funds (2-5 years), sticking with a majority of short-term bond investments is best.

What percentage of my portfolio should be in bonds? The old rule-of-thumb is to "hold your age in bonds". This means if you're 30, you should have 30% in bonds. If you're 80, you'd have 80%. As Americans are living longer now, the adjusted rule is to subtract 10% or 20% from your age (30 years old = 10% or 20% in bonds). This is a riskier approach than the old rule.

Think About Your Goals

Determining the right asset allocation strategy requires many factors.

Start by writing down your goals. Are they long-term or short-term goals? If you have mostly short-term goals, you need stable investments. Long-term goals (mainly retirement money) allow for more flexibility.

Think about it larger terms - what would happen if you lost 20-30% of your investment? Could you survive? Would you have the time to wait it out for the market to recoup? If you could not handle a large loss, investing in stable options is better.

For most people, a good combination of risky and less risky investments works best. However, there are special circumstances. Consider how much money you need and your timeframe to obtain it. For example, if you do not have any retirement savings yet, you may need an aggressive strategy. If you regularly make retirement contributions, though, a good allocation of stocks and bonds will likely suffice.

Are bonds a safer investment than stocks? Generally, bonds are considered to be safer than stocks, because bonds have a fixed interest rate and maturity date. However, bonds have risks too. The value is dependent on market interest rates, so bonds could lose value too.

Your Next Step

If you are ready to invest, start writing down your goals. What do you need the money for? When do you need it? These answers can help you get started on your investment strategy.

If you want to keep your risk lower, bonds are a good choice. However, if you want to make more money or take a higher risk, stocks often offer a better return. Determine your perfect strategy and start investing. The sooner you start, the more time you have to see a greater return on your investment.

Write to Kim P at feedback@creditdonkey.com. Follow us on Twitter and Facebook for our latest posts.

Note: This website is made possible through financial relationships with some of the products and services mentioned on this site. We may receive compensation if you shop through links in our content. You do not have to use our links, but you help support CreditDonkey if you do.

Subscribe to CreditDonkey: Get updates on the latest deals and keep up with the best money moves.
Your privacy is important to us. Unsubscribe anytime

Read Next:


Invest money and build wealth. Sign up to get our free email newsletter.
How to Get Free Stocks

Free Stocks

Discover 15+ platforms offering free stocks and bonuses - a fortune isn't essential.

About CreditDonkey
CreditDonkey is a personal finance comparison website. We publish data-driven analysis to help you save money & make savvy decisions.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed on this page are those of the author's alone, and have not been reviewed, approved or otherwise endorsed by any card issuer.

†Advertiser Disclosure: Many of the offers that appear on this site are from companies from which CreditDonkey receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). CreditDonkey does not include all companies or all offers that may be available in the marketplace.

*See the card issuer's online application for details about terms and conditions. Reasonable efforts are made to maintain accurate information. However, all information is presented without warranty. When you click on the "Apply Now" button you can review the terms and conditions on the card issuer's website.

CreditDonkey does not know your individual circumstances and provides information for general educational purposes only. CreditDonkey is not a substitute for, and should not be used as, professional legal, credit or financial advice. You should consult your own professional advisors for such advice.

About Us | Reviews | Deals | Tips | Privacy | Do Not Sell My Info | Terms | Contact Us
(888) 483-4925 | 680 East Colorado Blvd, 2nd Floor | Pasadena, CA 91101
© 2024 CreditDonkey Inc. All Rights Reserved.