Stocks vs. bonds: What’s the difference?
If you’re a newbie investor, you may have no idea what you’re doing when it comes to investing in the stock market. If so, don’t feel bad – you’re not alone. According to Gallup, in 2019, only a little over half of all Americans were invested in the stock market. But this is a huge mistake.
If you want to build wealth, especially long-term wealth, investing in the stock market is a necessity.
But why? Couldn’t you just invest in real estate, or precious metals like silver and gold, or even a new-fangled investment like cryptocurrency to reach your financial goals? While you could, you’d be missing out on one of the greatest (if not the best) wealth creators of all time.
If you’ve never invested in the stock market before, you probably have no idea where to start.
Maybe you don’t even know what an investment really is. One of the most common questions for newbies is, “What should I invest in?”
Two of the most common types of investments are stocks and bonds. This post will break down what stocks and bonds are, the differences between them, the benefits of holding them in a portfolio, and where you can purchase them.
But before we get into the specifics of stocks and bonds, I thought it might make sense to show why the stock market is such an amazing wealth builder.
Why Is the Stock Market Such a Good Wealth Builder?
The stock market helps people build wealth through the power of compounding. Most people, investors or not, are familiar with this term. Put simply, compounding is the growth of previous growth. When you earn $20 in a savings account, say, that $20 of earnings grows (or “compounds”) in the future. It’s a virtuous cycle!
If you haven’t seen how compounding affects wealth over the long term, you may not understand why investing in the stock market is such a necessity.
Here’s an example.
Let’s say we have two different people, savers A and B. Both are 35 years old, have $10,000 to invest, and are planning on retiring at 65 years old.
Saver A wants to invest in the stock market, so she decides to invest in a portfolio made up of stocks and bonds earning an average return of 6.8% per year.
Saver B has no interest in the stock market. In fact, he’s kind of afraid of it. As such, he decides to just park his money in a high-yield savings account earning 1.8% interest per year.
Let’s see how much of a difference this makes:
Compounding makes quite a bit of difference!
Saver A has increased her investment by more than seven times! Saver B, on the other hand, hasn’t even doubled his investment. Now imagine adding more to your pile each year and you can see how regular investing in the stock market makes a huge difference over investing in a savings account — or, even worse, not investing at all.
What Are Stocks?
Buying stock is like buying an extremely small stake of ownership in one company.
When a business issues stock publicly for the first time, they decide how many pieces of stock to issue. These are called shares. For example, a company may issue 100,000 shares for investors to purchase. Each share is considered fractional ownership in the company.
When you purchase one of these shares, you are holding a tangible piece of the company. This is commonly called equity. Because you are now a shareholder, you have benefits, such as voting rights in the company, along with a claim to that company’s earnings and assets.
However, the biggest benefit comes from seeing the value of your stock increase over time and sharing in the company’s profits.
The two main ways stocks build wealth are through capital appreciation and dividends.
Capital appreciation is when the price of a stock is worth more than when you purchased it. For example, if you purchased a share of Apple for $150 and later sold it for $300, that would be a capital appreciation of $150. This is the main way stocks help build wealth. Stocks typically average 6.8% growth per year. (But, it’s important to note, average is not normal. And some years, stocks lose money.)
Dividends are monies paid out to shareholders, often every quarter, for holding ownership in the company. (Not all companies pay dividends.) Dividends are paid per each share of stock you own. For example, if you own 100 shares of company X and their dividend per share is $.02, you’ll earn $2 in dividends. This income is a secondary way stocks help build wealth.
What Are Bonds?
Bonds, on the other hand, are securities issued by the federal government, local government, bank or other entity. Essentially, when you buy a bond, you’re lending money to the bond issuer. In exchange, the entity promises to pay you back the full amount of the loan, as well as interest while you hold it, in exchange for lending them money.
Bonds earn money in two ways: interest and capital appreciation.
Because a bond’s purpose is to provide steady income with less volatility, interest is paid out more frequently, typically twice a year, but depending on the bond and type, can even be issued monthly. These interest rates can vary widely depending on the type of bond and when it’s issued.
Compared to stocks, the capital appreciation of a bond is much lower. While stocks on average earn 6.8% in appreciation per year, a bond may only appreciate by 2.4% per year.
How Are Stocks and Bonds Different?
While stocks and bonds are similar in many ways, there are quite a few differences between these two asset classes. The main differences between them are their purpose in your portfolio, the risk associated with each, their performance, volatility, and their liquidity.
Stocks are meant to provide the greatest amount of return for your portfolio. Because they have higher potential for loss, stocks are considered higher risk. This higher risk corresponds to greater fluctuations in price in the market, meaning they are much more volatile than bonds.
Conversely, a bond’s purpose is to provide stability and income to your portfolio. Because they have lower potential for loss compared to stocks, bonds are considered relatively low risk. This lower risk translates to more stability, meaning they are less volatile than bonds.
Stocks and bonds also vary greatly in their performance. While the stock market returns an inflation-adjusted average of about 6.8% a year, the bond market only averages a return of 2.4% a year. Having both in your portfolio allows you to get the increased exposure to potential for returns with stocks while mitigating their risk using bonds.
Stocks and bonds differ in how liquid they are as well. A stock can be sold relatively quickly — any time while the market is open. A bond can be sold in different ways, but if the bond hasn’t matured yet, you may not get back the face value of your bond.
The Benefits of Stocks and Bonds in a Portfolio
Depending on your financial goals, you may invest more heavily in either stocks or bonds. Most portfolios use a combination of the two. That’s because the way stocks and bonds perform in the market complement each other.
For example, when the stock market is doing well, bonds tend to hold steady or decrease in value. When the stock market is doing poorly, investors typically flock to bonds, causing them to rise in value.
Having a combination of stocks and bonds in your portfolio keeps your portfolio diversified and minimizes risk.
Your asset allocation is the way your portfolio is structured, and is usually discussed in terms of how much stock you have in your portfolio versus bonds. For example, if your portfolio is 80/20, that means your portfolio is made up of eighty percent stocks and twenty percent bonds.
Your asset allocation will depend on many factors, including your age, income, risk tolerance, distance from retirement, and more. If you’re just getting started in investing, you may want to opt for a 60/40 split. This is considered pretty conservative. It’s a safe starting point.
Another rule of thumb you can use to get your asset allocation is to subtract your age from 100. The result is the percentage of your portfolio you should have in stocks. For example, if you’re 30 years old, you should keep 70% of your portfolio in stocks. If you’re 70 years old, you should keep just 30% of your portfolio in stocks. While rules of thumb like this are useful starting points, you’re really best served by having a plan for your asset allocation — then sticking to it.
If you’re unsure what your asset allocation should be, you can use this asset allocation questionnaire from Vanguard to help you figure it out.
Where to Buy Stocks and Bonds?
Although stocks and bonds are different types of assets, they can typically be purchased in the same place.
You can buy stocks and bonds using a number of different services, including brokerage firms, financial advisors, and mobile apps.
A brokerage firm — also called a broker — is a financial institution that allows you to buy and sell securities. Whether you’re investing in stocks, bonds, mutual funds, ETFs or REITs, brokerage firms are what most people use to invest.
A brokerage firm usually has additional features to help investors, such as advanced trading tools, educational materials, videos, webinars, and more.
Some of the most well-known brokerage firms include:
- Charles Schwab
- TD Ameritrade
A brokerage firm works great if you know what you want to invest in and are comfortable managing your portfolio yourself.
A financial advisor is used as an umbrella term for anyone that helps manage your assets – but not every financial advisor is the same.
Some financial advisors can craft a plan to help you build wealth, minimize debt, save for a particular goal, and provide advice over the long term. Others may simply execute trades on your behalf.
The type of financial advisor you’ll need will largely depend on your financial goals.
Another important thing to keep in mind is that financial advisors charge a fee. This fee can range from anywhere between 0.25% to 1% of your portfolio’s value, depending on the type of advisor.
When investing, it’s important to minimize fees as they can eat up lots of your gains. Still, some people choose to use a financial advisor because they believe it gets them better returns, even after the fee. In many cases, though, it doesn’t.
With the ubiquity of the cell phone, you can now purchase stocks and bonds on the go by using apps on your smartphone. Some of these apps, like Robinhood, allow you to purchase individual stocks. Others, like Stash and Acorns, invest through the purchase of mutual funds and ETFs.
Mobile apps are typically some of the easiest platforms to use for investing because they don’t charge high fees and they have low minimum balance costs.
Some of the most popular mobile apps right now are:
- M1 Finance
Check out our post on the best investing apps for 2020 here.
Investing in a portfolio of stocks and bonds (allocated based on your risk tolerance) is one of the best ways to build long-term wealth. It’s also one of the main tools I (and many other people) are using to become financially independent. In just three years, my investment portfolio has increased by almost 20%, earning over $5000 in market returns and almost $2000 in investment income, helping to inch me closer to my goal of early retirement by 45.
While this may not seem like a lot of money, any additional income you have in the market can help build your wealth snowball. And the sooner you start investing, the less time and money is necessary.
Whatever your financial-related goals may be, investing in stocks and bonds is one of the smartest, fastest, and easiest ways to get there.
Maybe you’ll even be able to retire early!
Plus, with today’s technology, the barrier to entry for investing is so low, it’s available to practically anyone with a cell phone. If you’re ready to take control of your financial life so you can build the life of your dreams, invest in stocks and bonds. You can do so for as little as $5 to start.