Bonds vs Stocks: How They Fit in Your Investment Strategy

When you begin investing, you’re likely to see two main asset classes: stocks and bonds. Both assets can work well in your portfolio, but it’s important to understand how they work before you move forward.

Let’s look at bonds vs. stocks and see how both might fit into your investment portfolio.

Bonds vs. stocks: How each works

It’s important to understand that bonds and stocks work a little differently from each other as you learn how to invest money.

• Bonds represent debt. You essentially lend money to a bond issuer, typically a corporation, local government, or the federal government, and they typically make regular interest payments. When the bond matures, or reaches the end of its term, the entity will generally repay the principal you provided.
• Stocks represent equity ownership in a company. For each share of stock you buy, you own a part of the company. You own that share of the company until you sell it. Depending on stock market conditions, you might take a loss when you sell or you might benefit from a gain. It’s also possible to receive dividends as a shareholder, depending on the stock you’ve invested in.

As a bondholder, you might be reasonably sure that you could receive ongoing income until the bond matures, as well as the amount you originally put in. With a stock, you can’t be sure that your investment will appreciate and provide you with gains.

Either way, both bonds and stocks are investments, and all investments come with the risk of loss. Even with a bond, if the company defaults on its debt, you could lose your principal and any remaining interest payments. With a stock, if the price falls and doesn’t recover, you could lose your investment.

Bonds vs. stocks: 4 important differences

When investing in bonds vs. stocks, it’s important to pay attention to key differences so you can decide how to use these assets in your investment portfolio.

1. Debt vs. equity

A bond is considered a debt instrument. You basically lend money to the entity, whether it’s a company or a government, and they commit to repay the amount you provided. Along the way, they typically pay interest at regular intervals.

Stock is equity — or ownership — in a company. As a stockholder, you might have some rights, including the ability to vote on the board of directors. Because a stock represents an ownership stake in the company, you might also see potential appreciation of your stock. If the company does well, you could get a share of that success in the form of a higher stock price when you sell. Additionally, as a shareholder, you might receive dividends if the company pays out some of its profits that way.

2. Bond vs. stock market

The bond market isn’t a central location, so many bonds trade on the over-the-counter (OTC) market. Some brokerages offer access to bonds, though the cost is usually higher than what you’d pay for a stock transaction. It’s also possible to access bonds through bond funds offered by asset managers and brokers. There are bond index funds, mutual funds, and exchange-traded funds (ETFs), which can offer diversification if you prefer to invest in multiple bonds rather than a single bond.

When it comes to U.S. government bonds, the easiest way to purchase them is to go to TreasuryDirect.gov. You can choose to open an account and buy Treasurys from the U.S. government.

Stocks, on the other hand, are often traded on central exchanges, though there are some over-the-counter places to buy stocks. Major exchanges like the New York Stock Exchange (NYSE) and the NASDAQ allow you to buy and sell shares through your broker. Today, many brokers offer stock trades with no transaction fees. You can also buy stock mutual funds and ETFs.

3. Risk level

Because they are considered debt, and you’re expected to see the return of your principal, bonds are generally considered less risky than stocks. But remember, all investments carry the risk of loss, including bonds. The interest payments you might receive from bonds could allow you to receive fixed income regularly. Even if the company or government ultimately defaults on the bond, you likely received some interest during the repayment term, so you likely got some of your money back.

Stocks are generally considered riskier than bonds. When you purchase a share of stock, you are hoping that the company does well and staking that success on the assumption the share price will increase. There’s no guarantee of a return on your principal, however. If the stock price drops and doesn’t recover, or if the company goes out of business, you could lose your investment — and there usually aren’t payments along the way, as you’d typically see with bonds, unless you receive dividends.

Purchasing shares of a broad-based stock mutual fund or ETF could help you build a diversified portfolio and might provide a measure of protection against market volatility. That way, you get exposure to the stock market as a whole, rather than relying on a single stock or a handful of stocks to do well.

4. Returns

Bond returns are generally lower than stock returns. A rule of thumb is that a lower-risk investment is likely to have lower returns than an asset that is considered riskier. Stocks, on the other hand, could potentially have higher returns than bonds. If the company does well, the stock price could skyrocket and you could see big returns. Of course, you could also lose your entire investment, depending on factors like company performance and financial market conditions.

Balancing your potential returns with your risk tolerance is an important part of creating a portfolio that meets your needs. Some investors like to use bonds as a way to potentially access regular income and relatively stable returns while including stocks for potential growth and wealth building.

What to consider before investing in bonds

When learning how to buy bonds, it’s important to consider the type of bond you’re looking at, as well as various possibilities that could potentially impact your returns.

Type of investment

There are different types of bonds, including corporate bonds, municipal bonds, and U.S. Treasury bonds.

• Corporate bonds generally fall into two categories: investment-grade and high-yield. Both are essentially loans made to companies, which could make them a higher-risk investment than other types of bonds.
• Municipal bonds are issued by state and local governments for various projects. The interest payments on these bonds could come with tax benefits. These are generally considered a low-risk investment.
• U.S. Treasury bonds are issued by the federal government. You can choose to buy bonds at TreasuryDirect.gov. These are generally considered one of the lowest-risk investments.

It’s also possible to invest in bond mutual funds and ETFs. These instruments allow you access to a variety of bonds with one investment. Bond ETFs trade like stocks on an exchange, which makes it easy to purchase shares. With funds and ETFs, you just make one purchase and have exposure to all of the bonds included.

Credit ratings

Bonds come with various credit ratings that are generally designed to reflect the level of risk. If a bond is considered high risk, with a lower credit rating, it could potentially offer a higher yield. You might see bigger interest payments, but there’s also a greater chance of default and you might lose some or all of your principal.

Before investing in bonds, check the credit ratings of the bond issuer and gauge how much risk you’re willing to take.

Risks

Don’t forget to consider other risks related to bonds. For example, a bond that’s considered low risk might have a low yield that doesn’t beat inflation. This is called interest rate risk. You could receive income from a bond, but it might not keep pace with rising prices. Additionally, there is a chance that a bond might be called in early. This call risk means that, though you get your principal back, you lose out on some of the interest payments you might have earned.

Carefully consider the purpose of the bonds in your portfolio before moving forward, and be sure you understand the potential risks.

What to consider before investing in stocks

Stocks also have their own important considerations before you add them to your portfolio. Here are some things to keep in mind before you choose stock investments.

Type of investment

In general, you can usually invest in individual stocks or buy fund shares. When you buy a share of a company, you are just getting access to that one company. You can add shares of several companies to your portfolio and receive potential gains from those investments.

On the other hand, you can also opt to purchase shares of funds. With a mutual fund, you make one purchase, but you receive a slice of ownership of everything in that fund. You can also buy stock ETFs, which also allow exposure to a variety of companies. Using mutual funds and ETFs can help you diversify your stock holdings as well as help you manage some of your risk.

Company stability

If you decide to invest in individual equities, it’s a good idea to have an idea of the company’s stability and research its fundamentals.

Some of the items to take into consideration include the company’s earnings record as well as balance sheet. Does the company have a track record of growing its earnings and managing its finances well? If so, that could potentially be an indication of stability and long-term staying power.

As you’re researching, also look at the company's price-to-earnings ratio, or P/E ratio. This is a numerical representation of how the stock price relates to the company’s earnings. It’s important to pay attention to when you grab these numbers and compare the P/E ratio of companies at similar times. Additionally, you can compare a P/E ratio of a company to the average of other companies in the same industry or sector to get an idea of relative performance. In general, a lower P/E ratio is considered an indication that a company might be undervalued compared to its potential earnings, which could mean you’re getting a good deal.

Risks

Stocks are generally volatile in the short-term, so you run the risk of losing money. You could also lose your principal if the company goes out of business, making your stock worthless. Additionally, some stocks don’t recover from market downturns.

Another risk you run when you invest in stocks is that you might need the money in your portfolio during a market event or downturn. This could force you into liquidating some of your positions at a loss, rather than holding on to them through a potential recovery.

How to get started

You can start investing in bonds and stocks by opening a brokerage account. There are a number of accounts that allow you to buy and sell individual stocks and bonds, as well as purchase shares of mutual funds and ETFs.

Some of the top online brokers, like Stash, let you start investing with a relatively small amount of money. With the right brokerage account, it could be possible to build your investment portfolio and potentially grow your wealth over time.

Read our Stash review to find out more about getting started with a small amount of money.

FAQs

The bottom line

Both bonds and stocks can be useful investments. Understanding the differences between them may help you figure out how to best allocate your assets in a way that reflects your goals, timeline, and risk tolerance.

Consider using bonds to provide stability and income in your portfolio, while using stocks for growth in your portfolio and building wealth over time.

Once you’re ready to get started, compare your options by checking out our recommendations for the best brokerage accounts.