We often hear the term “stocks and bonds” used interchangeably, as if they’re two sides to the same investment. They’re not.
In fact, they’re very different investments, but they’re often used in the same sentence because they complement one another.
The differences between stocks vs. bonds are pretty dramatic.
And that’s precisely why it’s usually best to hold both in your investment portfolio. While there are certain distinct similarities, they often provide different benefits in different types of market environments.
Most financial experts recommend that you have a portfolio balanced between the two. Other allocations, like cash, real state and commodities, may be recommended, but stocks and bonds are typically the primary investments.
Let’s take a look at both, and why you need them in your portfolio.
What Are Stocks?
The most basic feature of stocks is that they represent ownership in a business enterprise. Stocks are issued in denominations referred to as shares. Each share represents a fractional ownership in a company. For example, if a company has 1 million shares of stock outstanding, each share represents one-millionth ownership in the company.
Stocks can be either publicly or privately issued. If they’re publicly issued, they trade on stock exchanges, like the New York Stock Exchange or the NASDAQ. If they’re privately issued, they’ll be held by a small group of individuals, each with a substantial percentage of ownership in the business.
Companies issue stock as a way of raising capital, typically to expand a business. The business may start out as a small closely held concern. But as it expands, and needs capital, it can issue stock to investors as a means of raising money. For example, the business might issue 1 million shares of stock at $10 each. That will raise $10 million in capital.
A company can choose to raise capital by issuing stock, rather than going into debt. Debt may involve getting a loan from a bank, or issuing bonds. Either would create an obligation for the company, that would require the payment of interest. It would also require the eventual repayment of the loan or bonds.
But by issuing stock, there are neither interest payments nor the need to repay the capital raised. Investors buy stock to have an ownership stake in what they believe will be a profitable company. Companies sometimes pay dividends on stocks. But investors might be more interested in the price growth potential of the stock than anything else.
The Benefits of Owning Stocks
Stock investors look to make money in one of two ways, and sometimes both:
- From dividends paid on the stock, and/or
- Capital appreciation on the stock price.
For example, a stock might pay and annual dividend of 3%. But it may also have the potential to rise by 10% or more annually. This can happen if the company shows a steady pattern of both rising revenues and increasing profits.
In fact, based on the S&P 500 index, stocks have returned an average of about 10% per year between 1986 and 2016. There’s even some evidence that rate of return goes all the way back to 1928. Keep in mind however that the return includes both dividend yield and capital appreciation.
But that’s just the average return.
Few investments have provided such generous returns for so long as stocks. The 10% average return is just that – an average. There have been stretches of several years where the market has provided much higher returns.
The Risks of Owning Stocks
The hope of course is always that a stock will rise in value. Closer to the truth, it’s hoped that it will explode, and make the investor rich!
More commonly, stocks tend to grow very slowly over time, or even trade in a narrow range. But some fall in value, and some fall by a lot. Others eventually become worthless, as their business deteriorates, or the promised growth doesn’t materialize.
This is the risk the investor takes any time he or she buys a stock. The hope is always that it will rise and make the investor rich, or at least provide steady gains. But some stocks languish, and some go in only one direction – down. It’s even possible to lose 100% of your investment in a single stock.
Making the outlook even more uncertain is that there are so many factors that can cause the stock to fall. Some examples include:
- The passing of laws or regulations that are unfavorable to the company or to one of its primary products or services.
- A lawsuit against the company.
- Currency risks for a company with substantial international operations.
- The failure of an important product line or service.
- The arrival on the market of a superior competitor.
- A series of missed earnings reports.
- The company might cut or suspend its dividend.
- The withdrawal of a major client (or several clients) of the company.
- A general decline in the financial markets, which can have an especially severe impact on an individual company.
- The development of a technology that renders one or more of the company’s products obsolete.
That’s just a few samples of what can go wrong with a stock. Each represents a risk that the investor takes in buying shares in a particular company.
Different Types of Stock
When we talk about stocks, we’re not talking about a single type of stock. There are actually several. Some examples include:
Common stock. This type of stock represents a general ownership stake in the company. Common stockholders elect the company’s board of director and vote on corporate policy. But in the event of liquidation, they get in line behind bondholders, preferred shareholders, and other individuals and entities with superior lien positions.
Preferred stock. These shares usually don’t have voting rights. But preferred stockholders are eligible to receive dividends before they’re paid to common stockholders. Preferred stock functions somewhat like bonds, in that they have fixed dividend payments. But unlike bonds, they also offer the potential for capital appreciation.
Other classifications of stock are based more on performance than official definition:
Growth stock. This is the stock of a company that invests its profits primarily in growing the business. The stock may not pay a dividend, or offer only a very small one. Investors in growth stocks are betting primarily on capital appreciation, not income.
Dividend stock. The company behind this type of stock pays out much of the company’s profits in dividends to shareholders. The stock may offer some amount of capital appreciation, but the primary attraction is the dividend yield. That yield is often higher than what’s available on bonds and short-term debt securities.
Value stock. These are stock in companies that are considered out-of-favor with the general investing public. It usually happens after a stock has sustained serious losses. Investors might buy into these companies if their fundamentals are strong (despite the share price drop), or if it looks like they’ve turned the corner and are improving. Value stocks are one of the most time-honored ways to make money in stocks over the long-term.
Investing in Stocks Through Funds
While it’s common to invest in individual stocks, investing in funds has grown in popularity in recent years. There are two primary types of investment funds:
Mutual funds. These are portfolios of stocks, often representing major companies in an industry segment. They’re generally run as actively managed funds, because they regularly add new stocks, while selling off others. Because of this activity, they often generate more taxable capital gains.
As well, the usually carry higher fees. These are often referred to as “loads”.
A load is equal to one point, or 1% of your investment in the fund.
The fund may charge a 3% load when you purchase shares in the fund. Alternatively, they may charge a 2% load when you buy, and a 1% load when you sell within a certain timeframe.
Exchange traded funds (ETFs). These are funds that invest in stock market indices. For example, a common index is the S&P 500 index. An ETF will invest to match that index. As a result, stocks will turn over in the fund only when the index is reconfigured.
For that reason, ETF’s are commonly referred to as passively managed funds.
Why Many Investors Prefer Investing in Stocks Through Funds
An investor might invest in a fund as a way to simplify stock investing. The investor can purchase shares in a fund, which represent a portfolio of stocks. There’s no need for the investor to pick individual stocks, and manage the portfolio.
Funds also spread investment risk. If you purchase an individual stock, there’s always the possibility that it’s price can tank. But if you buy into a fund, there can be dozens or even hundreds of stocks in the fund. A collapse of any one (or even several) won’t dramatically impact your investment.
Funds also provide an opportunity to invest in specific market segments. For example, an investor can choose to invest in high-tech, healthcare or energy. She can also choose domestic or international stocks.
There are even sector funds that invest in companies by size. Those include the following:
- Large cap stocks – generally companies with a market capitalization greater than $5 billion.
- Mid-cap stocks – generally companies with market capitalizations between $1 billion and $5 billion.
- Small cap stocks – this sector is made up of companies with market capitalizations of less than $1 billion.
At each phase of a bull market, companies of any of these three size classifications could outperform the others. Sector funds provide an opportunity for investors to take advantage of that situation.
What Are Bonds?
Bonds are debt obligations of an institution. The issuer can be a corporation, the federal government, state, county or municipal governments, or foreign governments. They’re issued at a fixed face amount, with a certain term, and a specific rate of interest.
Bonds are issued in denominations of $1,000. Interest is usually paid twice annually. For example, a corporation may issue a $1,000 bond with a 5% interest rate (referred to as a “coupon”). Interest will be paid on the bond every six months, at $25 per payment.
Bonds can be issued for a variety of purposes. A corporation may issue bonds to pay for plant and equipment, the acquisition of another business entity, or to consolidate other debt. Governments may issue bonds to finance capital improvement projects, pay general obligations, or retire other debts.
There does tend to be some confusion as to exactly what bonds are. Generally speaking, they are longer-term interest-bearing securities. They typically run more than 10 years. However, within the investment community, the definition of bonds is often more general. Investors may casually refer to any interest-bearing security as a “bond”.
Shorter-term debt securities actually go under different names. For example, a security with maturity between one year and 10 years is generally referred to as a “note”. Securities with maturities of less than one year are “bills”, or various proprietary titles.
Bank issued certificates of deposit typically run between 30 days and five years, and are never referred to as bonds.
The Benefits of Owning Bonds
The basic purpose of owning bonds is to create a steady income stream, with preservation of capital.
Interest income. The interest paid on bonds provides the income stream. Unlike dividends, which can be adjusted higher or lower, bond interest is fixed for the term of the security. If a company issues a 20-year bond, the rate will continue for the full term. This makes the income stream from the bond completely predictable.
What’s more, because they’re longer-term securities, bonds generally pay higher rates than bank investments.
Preservation of capital. Safety of principle is the other primary goal. As long as a bond is held to maturity, the full face value of the security will be paid by the issuer.
Investment diversification. Because bonds pay a fixed rate of interest, and guarantee principal payment at the end of the term, they’re generally considered to be safer than stocks. That doesn’t mean bonds are 100% safe. But their values are generally more reliable than stocks.
For that reason, bonds are typically held as a diversification to stocks in a well-balanced portfolio. The position held in bonds lowers the overall volatility of the portfolio. It helps the portfolio retain value during stock market downturns.
The Risks of Owning Bonds
There are four primary risks involved in owning bonds:
1. Default by the issuer. Other than bonds issued by the US government, every bond in existence has the risk of default. A corporation could go out of business, leaving its bonds worthless. And while the occurrence is rare, even municipal governments can default on their bonds.
In the event of default or bankruptcy, a bondholder may get less than the face of the amount of the bond, or even face a period of time when interest payments would be suspended. In extreme circumstances, the bonds could become totally worthless.
2. Inflation. This has to do with both the changing rate of inflation and the long-term nature of bonds. Let’s say you purchase a 20-year bond at an interest rate of 4%. With an inflation rate of less than 2%, that’s a solid return.
In the next few years, the rate of inflation rises to 5%. You’re now getting a negative rate of return on your bond. With inflation at 5%, and the interest rate of 4%, you’re losing 1% per year in real terms.
This is why bonds tend to do poorly during times of rising inflation.
3. Currency risk. This is a risk that applies to foreign bonds, whether issued by foreign corporations or governments. Bonds are typically issued in the currency of the issuer’s country. Should the value of that currency drop against the US dollar, the value of your bonds could fall.
4. The biggest threat to bonds: Rising interest rates
As a bond investor, you must always be aware of this relationship.
In the inflation example above, we focused on the impact of inflation alone. But accelerating inflation will cause higher interest rates. If the rate on comparable bonds rises to 7% in order to cover the higher rate of inflation, the bond you purchased at 4% will lose market value.
Depending upon how close you are to the maturity date, the value of a $1,000 bond might fall something like $700 if you were to sell it on the open market. The value of the bond will fall until it can be purchased by other investors at a price that will come close to the current 7% yield on bonds.
You will still get the full $1,000 if you hold the bond to maturity. But then you will also have the opportunity cost of holding a bond with a below-market interest rate.
This is probably the single biggest risk to owning bonds.
Different Types of Bonds
This is where bonds get a bit complicated. They actually come in several different “flavors”:
Corporate bonds. As the name implies, these are bonds issued by corporations for various purposes.
Convertible bonds. These are also corporate bonds, but they come with a provision enabling them to be converted to company stock. They can be converted at specific times to a certain amount of stock. The bondholder can choose to make the conversion.
High-yield bonds. Once called “junk bonds”, these are bonds paying higher interest rates, by issuers with low credit ratings. It’s a classic example of a higher return/higher risk investment.
U.S. Government bonds. These are debt obligations of the US government. They’re, commonly called “treasuries” because they’re issued by the US Treasury Department. Treasury bonds are issued in terms of 20 and 30 years. There are shorter-term securities issued for as little as four weeks.
US Treasury securities are considered the safest of all investments, since they’re issued by the US government. But treasury bonds do have the same inflation and interest rate risk as any other bond.
They can be purchased in denominations as low as $100 through Treasury Direct.
Municipal bonds. These are securities issued by states, counties, and municipalities. The primary attraction is that the interest paid on these bonds is tax-free for federal income tax purposes. The interest is also generally tax-free in the state of issuance, but not in other states.
Foreign bonds. These are bonds issued by foreign governments and corporations. Investors may purchase them because they pay higher interest rates than domestic bonds. They have all the risks of other bonds, but also foreign currency risk.
Investing in Bonds Through Funds
Because of high face values, and the fact that bonds often must be purchased in minimum amounts (like 10 bonds for $10,000), it can be difficult for all but the wealthiest investors to diversify adequately.
That’s why bond funds are often preferred by smaller investors.
Bond funds also offer an opportunity to invest in specific types. For example, you can invest in a fund that holds only high-yield bonds. You can also choose to invest in a fund that holds bonds that are within a few years of maturity. This can be a way to secure a certain rate of interest, without accepting the risk that comes with holding long-term bonds from beginning to end.
The Differences Between Stocks vs. Bonds
In theory at least, stocks and bonds counter each other. Stocks represent equity in companies, and have the potential to generate capital gains. Bonds provide safety of principal and stable income.
But some of the differences between the two can be a bit blurred. For example, there are stocks that pay dividends that are equal to or higher than bond interest. Bonds also have the potential to generate capital gains in a financial environment where interest rates are falling. (It’s that inverse relationship with interest rates bond have, but with a positive outcome.)
How Bonds Can Behave Just Like Stocks
Because of interest rate risk, long-term bonds can often behave like stocks. I just explained how bond values can rise in a declining interest rate environment. But we’ve also covered the major risk that rising interest rates pose to bonds.
Because of swings in interest rates, a 20- or 30-year bond can experience significant swings in value. If a bond has 20 or more years to run, it can behave a lot like a stock. It can rise and fall with changes in interest rates and inflation.
What’s more, stocks also tend to be interest rate sensitive. Since interest-bearing investments compete with stocks for investor capital, rising interest rates often have a negative impact on stocks. (They also raise the cost of borrowing for the company, lowering its profits.) Falling interest rates have a positive impact.
In that way, stocks and bonds can actually perform in a similar way.
Investing in Both Stocks and Bonds – And Why You Need Both
The basic reason to invest in both stocks and bonds is to balance equity participation with capital preservation. Stocks provide the first, and bonds provide the second – at least to some degree.
Exactly how much you should hold in bonds is an ongoing debate. There are only theories.
One is that your stock holdings should represent 100 minus your age. Under that formula, if you’re 30 years old, 70% of your portfolio would be invested in stocks, and the rest in bonds. Conversely, a 70-year-old would have 30% in stocks (100 – 70), and 70% in bonds.
That looks a bit too conservative for the 30-year-old. But it might be a good mix for the 70-year-old.
Another is that your stock holdings should represent 120 minus your age. Under that formula, a 30-year-old would have 90% in stocks, and 10% in bonds. Conversely, a 70-year-old would have 50% in stocks (120 – 70), and 50% in bonds.
That sounds about right for the 30-year-old, but it might be a bit too aggressive for the 70-year-old.
Should you use either of these formulas?
I’d say use them only as a starting point. You also have to take into consideration your own risk tolerance. If you’re 30 years old, you might not be entirely comfortable having 90% of your portfolio in stocks. That being the case, lower the stock allocation somewhat until you’are more comfortable with the mix.
Whatever formula you use, a well-balanced portfolio has both stocks and bonds – and at least a little bit of cash. Properly allocated, it can maximize growth, while minimizing risk. That’s the whole reason you need both stocks and bonds in your portfolio.