If you’re interested in making money through investing, you’ve probably heard lots of talk about two big types of investments: stocks and bonds.
Both stocks and bonds can be great options for new investors. But what’s the difference between them — and how do you know which one’s right for you?
Here’s the lowdown on stocks and bonds, plus some tips on picking the one that will best help you achieve your financial goals.
What Are Stocks and Bonds?
Stocks and bonds are two major types of investments you’ll find in investment portfolios. But as we’re about to see, they serve very different functions and carry very different levels of risk.
What’s the Difference Between Bonds and Stocks? (Video)
What Are Stocks?
Stocks are publicly-traded companies — that is, companies that have decided to sell shares of their ownership to investors on the stock market.
In exchange for purchasing the shares, investors receive partial ownership of the company. The exact percentage of ownership is proportionate to the number of shares the investor owns.
Additionally, many companies offer perks to major investors, such as voting rights in company leadership elections and special incentives on the company’s products or services. And some companies share their profits with shareholders in the form of dividend payments.
How Does Investing in Stocks Work?
Stock prices — that is, the price of one share of the company’s ownership — fluctuate based on supply and demand. A popular company that’s bringing in lots of income will be more in demand, driving the stock price up.
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Conversely, if a company isn’t doing well, shareholders will want to jump ship — and few people will want to replace them. The price of the stock will drop as demand does.
Traders make money on stocks by trying to predict how supply and demand will rise and fall. By purchasing shares when the price is low and selling them when it’s high, they can see huge returns on their investment.
But if investors judge the market incorrectly, they could buy too late or sell too early, losing out on even more earnings. And if the stock crashes, the price could plummet, causing the investors to lose their original investments altogether.
What Are Bonds?
Like stocks, bonds allow people to make money by investing in a company. But while stocks represent ownership in a company, bonds represent a company’s debt to the bondholder.
And they’re not limited to companies, either: many local, regional and federal governments also issue bonds to investors.
Essentially, a bond is a small loan. By purchasing one, you loan the issuing company or government the purchase price of the bond, and the borrowing entity promises to pay you back with interest.
Bonds can be traded between investors prior to maturing (reaching the date at which they must be fully repaid). But they can also be held by one investor until they mature, allowing the investor to receive annual interest payments during the bond’s lifespan.
How Does Investing in Bonds Work?
When you purchase a bond, you’re given several pieces of information: the maturity date, coupon and yield to maturity.
The maturity date is the date that the bond will be fully repaid. And the coupon is the amount of interest the bondholder will receive, displayed as a percentage of the face value of the bond.
Yield to maturity represents the total amount of interest that the investor will receive over the lifetime of the bond — in other words, the profit to be made from the investment.
Once you own the bond, it’s simply a matter of holding onto it until it matures. You’ll receive periodic interest payments from the bond issuer, and when the term is up, you’ll get your principal investment back in full.
Should I Invest in Stocks or Bonds?
A diverse investment portfolio often contains both stocks and bonds. But if you’re just beginning to invest, you may want to pick just one to start — here are some things to consider when making your choice.
Stocks Are Riskier than Bonds — But May Have Higher Rewards
Because a bond is essentially a loan, it comes with a promise of repayment, with terms already spelled out at the time of purchase. Barring a default, which is very rare with investment-grade bonds, the issuing entity is obligated to repay your investment with interest by a certain date.
This makes bonds very stable investments, ideal for soon-to-be retirees or others who don’t want to risk losing their principals. But because bond issuers don’t want to make promises they can’t keep, the interest rates on bonds tend to be low, leading to smaller returns on investments than you might get with stocks.
With stocks, companies make you no promises: you bought the shares, and whatever happens next is your problem. If the company does well, you could sell your shares and get a high return — but if it doesn’t, you could lose your investment, and that’s a risk you have to accept when trading stocks.
However, because stock prices are always in flux, a smart investment could earn you far more than any bond could. The interest rate on a bond could be as low as 2%, whereas if a stock you own doubles in price, you could sell it and profit 100%!
Stocks Can Earn You Money Quicker than Bonds
The stock market moves at a breakneck pace — and so can the value of your stock portfolio. You can buy and sell stocks whenever you want, which means that you could be making money the same day you start trading.
Bonds, on the other hand, make you wait to reap your full rewards. This wait could be anywhere from a year to 30 years, depending on the length of the bond — and while you can sell the bond before that, you’ll miss out on the remaining interest.
Stocks May Have a Lower Barrier to Entry than Bonds
Depending on the exact stocks you select, you could purchase your first shares for just a few dollars and still see big returns. This makes them accessible to all investors, regardless of budget.
Bonds, however, are typically sold in increments of $1,000, so you’ll need to have at least that much on hand to purchase one. This can put them out of reach if you’re starting off with less than a grand of investment capital.