Investing 101: Stocks Vs Bonds
Understanding the difference between stocks and bonds is essential to making intelligent investment decisions, since these two asset classes for the core of any prudent asset allocation plan. Both can be profitable investments (and most investors should own both), and each has their own specific associated risks.
Stocks give their investors part ownership of a company. Stockholders benefit from company profits and have a greater potential to appreciate in price than do bonds; however, they are generally much riskier. Over long periods of time, stocks are expected to out-perform bonds. That is, because stocks are riskier to own, investors demand a higher expected return to buy them.
Stocks are traded on public stock exchanges, such as the New York Stock Exchange (NYSE), Nasdaq, and American Stock Exchange (AMEX). Their prices are updated constantly throughout the trading day, and all but the smallest of penny-stocks tend to be very liquid, meaning they can be bought or sold at a moment’s notice without affecting the price.
Bonds are loans made by investors to a corporation or government entity. Bond holders are promised a fixed rate of interest, expressed as a percentage of the initial offering price of the bond (or current price if bought on the secondary market). If held to maturity (and the issuing company doesn’t go bankrupt), the bond holder’s rate of return will be equal to the interest rate. New bonds are generally sold in increments of $5000.
A bond has a maturity date. Upon reaching maturity, a bond’s principal amount is returned. Theoretically, a bond’s maturity can be pretty much anything, but they tend to be issued in increments of 1, 3, 5, 10, 15, 20, and 30 years. The risk with bonds is that the principal amount will not be paid back due to some unforeseen circumstance. The more credit-worthy a company, the safer the bond is seen to be and the lower the interest rate it will pay. Credit ratings vary from the high AAA to a low rating of D and are provided by firms like Moody’s Investor Service and Standard and Poors.
Bonds issued by the U.S. government are commonly viewed as being virtually risk-free investments, or at least as close as it’s possible to get. Blue chip corporations with strong balance sheets are also consider to be a safe bet for investors. Bonds are sold and purchased on the open market, so their value can increase or decrease depending on prevailing interest rates.
Bond prices move inversely to interest rates. When interest rates go up, bond prices go down. When rates are down, bond prices rise. For more, see How To Choose A Bond Mutual Fund and The Bond Style Box Explained.
One, The Other, Or Both?
Every portfolio should contain both stocks and bonds, the only question is, how much of each? Stocks offer the best chance of earning excess returns over the rate of inflation, but are too volatile to hold on their own. Bonds offer stability, but tend to have lower long-term returns. How much to allocate to each asset class is a very personal decision, but one common rule of thumb is to have 120 – [your age] in stocks, so a 30 year old would allocate 90% of their portfolio to stocks and 10% to bonds.