Stocks vs. Bonds | Understanding the Pros & Cons of Each

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New investors are sometimes confused about the difference between stocks and bonds. These are two types of financial investments that seem similar on the surface. But when you start to peel back the layers of the onion, you start to see that they’re actually quite different.

What are Stocks?

A stock is a type of investment that involves purchasing a piece of a publicly shared corporation.

When you buy a stock, you are literally purchasing a tiny piece of ownership stake of that company. The more shares you accumulate, the more ownership and more voting rights you have. You can buy a small fraction of a stock or you can buy dozens of shares at a time.

The stock market can provide both explosive short-term gains and steady long-term returns. When you buy shares in a single company, you end up with a higher risk investment because all of your eggs are in one basket, so it’s important to put together a diversified portfolio.

How to Buy Stocks

Buying stocks is relatively simple. All you have to do is select a brokerage firm like Robinhood or Schwab, set up the type of account that works for you (like an individual or joint account, or a retirement plan such as an individual retirement account or Roth IRA), and then fund the account.

Once you are set up on the broker’s platform, you are presented with several stock investment options.

Individual Stocks

Individual stocks can be highly volatile, meaning their price can fluctuate significantly over time. In other words, stock prices can rise or fall rapidly over the course of a day, quarter, or year.

For large, stable companies, that can mean a swing of 5% to 10% or more in a single day, while smaller, lesser-known companies can experience much larger ups and downs. Over years and decades, long-term companies — think Amazon or Apple — generally climb steadily upward. On the other side, fly-by-night companies and penny stocks can easily take your investment down to zero.

There are many strategies that you can use to assess the value of individual stocks. Many investors look primarily at the quality of the company, its leadership, and its prospects. Others check on the stock price, looking for an entry point they find attractive, or poring over financial statements. Others see whether a company they like is positioned on a leading exchange like the S&P 500 or the NASDAQ. Most experienced and successful investors develop their own strategies that they refine over time on their hunt for great investments. But it can be a lot of work.

Index Funds

Instead of buying individual stocks, an easier path is to buy index funds, which are portfolios that follow or track a specific market index (e.g., the Dow Jones). Truth be told, this is probably a good starting point for new investors because it offers instant diversification across many companies, and it allows you to track an index or an industry rather than relying on your own insights to pick a single winner.

When you buy a fund, you can access a large number of companies instead of just one at a time. The fund’s composition and price fluctuates depending on the state of the specific index that it follows.

Most index funds are passively managed, meaning they follow a specific segment independent of any human intervention. In other words, account managers do not actively add or remove funds to improve performance.

Mutual Funds

In a mutual fund, an investor pools money from a group of investors and purchases baskets of securities.

Unlike index funds, mutual funds are actively managed. In other words, a fund manager adds and removes specific companies to try and improve the fund’s performance. The point of a mutual fund is to try and make strategic modifications to try and beat a specific market index or benchmark.

Mutual funds typically have higher fees, and they are not guaranteed to outperform index funds. In fact, fewer than half of all mutual funds tend to beat the market when you include the cost of their fees. However, they come with the upside of potentially higher growth if the fund manager makes the right choices. Caveat emptor.

ETFs

Just like mutual funds and index funds, ETFs are made up of many different companies or asset classes (e.g., commodities). So when you buy an ETF, you can invest in many different companies without having to buy them individually.

In an ETF, a fund provider designs a fund and then sells shares to investors. Unlike index funds, which are bought and sold based on the price at the end of the trading day, ETFs are traded continuously throughout the day.

Pros of Stocks

Higher Returns

Stocks can increase exponentially if a company performs very well. Just imagine if you gobbled up 100 shares of Amazon after its initial public offering (IPO). Back then, each share cost under $10. Today, they sit at more than $3,000 apiece. Do the math. As such, it’s possible to buy many shares of a company at a value price and benefit from explosive growth.

Liquidity

If you buy stocks through a brokerage account that is not set up for retirement, you can easily buy and sell them as needed. You’ll have to pay capital gains tax on any gains, and you’ll also have to pay taxes on dividends and any interest you accumulate. And beware, taxes are higher if you hold the shares for less than a year.

Dividends

Some stocks pay dividends, meaning you’ll receive cash payouts at periodic intervals. Dividends can be reinvested automatically to earn more shares.

Dividend growth investing is a popular strategy used by many investors.

Cons of Stocks

Higher Risk

Just as stocks can increase exponentially in value, they can also swing the other way — resulting in some painful speed bumps on your way to financial independence.

In other words, you can potentially lose all of your money in the stock market if your investments lose their value. A penny stock that looks like a cheap way to get rich quick might turn out to be a pump-and-dump scheme where unscrupulous investors and organizations hype a worthless stock, driving up the price, then leave the newbie investors out in the cold when the schemers sell their momentarily inflated shares. You’ll still retain your overall shares if a stock crashes, but they’re pretty much worthless.

That’s why successful investors minimize their risk by investing in companies they understand and have researched. After all, it’s pretty unlikely that Amazon is going to go out of business.

Stockholders Are Paid Last

If a company goes belly-up financially, stockholders are the last to receive payouts. So maybe limit your choices to stocks that trade on the New York Stock Exchange (NYSE) or the NASDAQ exchange — odds of overnight bankruptcy for companies on those platforms is pretty slim.

It’s an Emotional Experience

One of the hardest things to do in the stock market is to avoid getting emotional and making rash decisions out of panic or fear when market conditions change. This is why it’s so important to have a diversified portfolio that can help protect you against potential market swings.

Additionally, temperament is critical. If your investments keep you awake at night, stocks probably aren’t for you. And keep in mind that you should never invest money that you can’t afford to lose or will need within the next three to five years. So many new investors freak out if their stock drops 10% in a day.

Savvy investors see those drops as buying opportunities if they believe in the company — it’s stocks on sale!

What are Bonds?

A bond is a type of debt instrument that a company sells to investors to raise money.

In other words, when you buy into bond funds you essentially give a company a loan. In exchange, the bond issuer or lender gives the bondholder a coupon and agrees to pay you back with interest by a certain time.

All bonds have maturity dates, which is an official expiration date. When a bond reaches maturity, you are paid in full (assuming the company does not go under in the meantime and makes good on the payment). At that point, you can choose to keep your money or buy another bond.

How to Buy Bonds

Bonds can be bought in a few different places. For example, you can buy bonds through an online broker, just like you would purchase a stock. Or, you can purchase bonds through an ETF. Some ETFs buy bonds from several different companies and hold them for short, medium, and long periods of time.

Another way you can buy bonds is from the U.S. Treasury Direct website. If you take this approach, you can buy government bonds without having to pay a broker or middleman fees. If your goal is diversification, it’s not a bad idea to include bonds in your portfolio.

Types of Bonds

Corporate Bonds

A corporate bond is a type of bond issued by a company. A corporate bond may be issued for several reasons, such as for debt refinancing, expanding, making capital improvements, or funding an acquisition. As such, it’s a good idea to read the prospectus to find out what the funds are going toward.

Always look into the overall state of the company to assess the likelihood of your money coming back in full.

Junk Bonds

A junk bond is a type of investment that carries a riskier likelihood of default. A junk bond differs from a regular bond because of the issuers’ poor credit quality.

A junk bond can boost your overall rate of return as they come with higher yields than standard investment-grade bonds. But, as the name implies, they are hardly your most safe or stable investment opportunity.

Government Bonds

You can also buy bonds from the federal government and local municipalities (municipal bonds), just as you would buy a corporate bond. There are a few types of lucrative government bonds to explore. Oftentimes, however, you’ll get a lower return with a government bond compared to a corporate bond. As such, it’s worth assessing your options before buying into the bond market.

Savings Bonds

The Treasury offers series EE savings bonds, which have a fixed rate of interest. These are typically long-term bonds which can double by the time they mature.

Treasury Notes

Treasury notes or T-notes mature in shorter intervals of two, three, five, or 10 years. They offer fixed coupon returns and usually have a face value of $1,000 or higher.

Treasury Bonds

Treasury bonds or T-bonds are long-term bonds that mature within 10 to 30 years. T-Bonds provide interest or coupon payments on a semi-annual basis and come with a $1,000 face value.

Treasury Inflation-Protected Securities (TIPS)

TIPS are government bonds that protect against inflation. In other words, the principal of TIPS loans increase and decrease according to the Consumer Price Index. When a TIPS bond matures, the investor is paid the adjusted principal or original principal, depending on which amount is greater at the time. TIPS bonds pay interest twice a year at a fixed rate.

Pros of Bonds

Lower Risk

Buying bonds is not entirely secure. But they can provide stability to protect against market volatility. Investing in bonds can provide a fixed interest rate, guaranteeing a return over time.

Priority Payouts

Bondholders are given priority over shareholders, meaning they get paid first during liquidation. So if a company goes under, bondholders have a better chance of collecting payment. It might seem like common sense, but always consider investing in companies that appear to have a low chance of going out of business.

Long-term Gains

Investing in bonds is a solid long-term financial strategy, as they offer diversification from equities and stable returns. They also come with flexible maturity dates.

Cons of Bonds

Limited Liquidity

Just like with a certificate of deposit (CD), a bond can be cashed out early. However, you may be hit with a penalty for doing so. For example, certain bonds can require you to forfeit several months of interest if you liquidate them before their maturity date. If this sounds like bad news, you might want to look into a high-yield savings account instead.

Limited Growth Potential

Most bonds come with fixed interest payments. As a result, you limit your earnings by investing in bonds. If you think that a company is due for explosive growth, consider investing in shares and bonds at the same time to maximize your earnings potential. If you only invest in bonds, you may miss out on a large capital gain.

FAQ

Below are answers to some of the most common questions I receive about stocks vs. bonds.

What is an investment-grade bond?

A bond is considered to be investment-grade when the resources of the issuers are enough to indicate that they can safely repay bondholders.

An investment-grade bond is still somewhat risky, but it’s considered safer than a junk bond.

What is a preferred stock?

Preferred shareholders have more of a say in a company’s overall income. As a result, they are given dividends before common shareholders. Preferred stocks are considered to be less risky than common stocks, but they are still riskier than common bonds.

What does asset allocation mean?

Asset allocation refers to an investment strategy that involves spreading investments around to reduce risk and maximize rewards.

When you allocate assets over a portfolio, you typically diversify them by investing in a mix of secure and risky investments. In other words, you may buy a mix of secure bonds, risky stocks, and long-term index funds and mutual funds.

Are junk bonds safer than stocks?

If you’re looking to invest in a risky company, a junk bond is typically more secure. This is because if the company goes out of business, bondholders are paid before stockholders. At the same time, a bond can help you avoid market volatility.

That said, both options do come with risk. Maybe it’s just me, but I’d think twice about buying a financial product with the word “junk” in it.

The Bottom Line

Investing in stocks and bonds can help you diversify your investment portfolio and spread risk around. Both options can help you get ahead when investing while also providing greater security.

Whether you invest in the stock market or explore the bond market and purchase securities from companies or the United States government, you will be making a great financial decision for your future self.

Figuring out an investment strategy that works for you is no easy feat. Consider working with a financial advisor to devise a strategy that balances your long-term financial goals with your appetite for risk, and you’ll be just fine.

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