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How are Stocks and Bonds Different?

Stocks and bonds represent different ways to invest in a company or government. A bond usually offers interest income and the return of the principal investment, whereas a stock represents partial ownership in a company and is typically designed for capital appreciation. Bonds tend to be more appropriate for conservative investors, while stocks are well-suited for more aggressive investors.

For most investors, a mix of both is often the best solution.

When it comes to investing, we often hear that it is prudent to diversify, or spread out, our hard-earned money into various bonds and stocks. And while this makes intuitive sense, it is essential to understand the main differences between bonds and stocks before we start building a portfolio.

Like items on a grocery store shelf, in the world of investing, bonds and stocks are considered products. Having a thorough understanding of the purpose and characteristics of these products is extremely valuable for the novice investor. Let’s dive in and explore some of the key differences you’ll want to know before putting bonds and stocks into your shopping cart.

What are Bonds & Stocks?

Bonds and stocks exist because many institutions around the globe want to raise funds for various purposes. Businesses and governments seek out investors that are willing to provide those funds with the expectation that they will be compensated for putting their money at risk. They use the proceeds from a bond or stock offering for immediate needs like operating expenses or longer-term growth plans such as store expansion.

The primary sellers, or issuers, of bonds are governments, government agencies, and corporations. In the U.S., government bond issuers include the federal government as well as state and local governments. Bonds issued by state or local government authorities are referred to as municipal, or “muni” bonds. When we purchase a bond, we become a bondholder, or creditor, to the bond issuer.

On the other hand, stocks are typically issued by public corporations. Governments are not issuers of stock, but many corporations issue both bonds and stocks. Stocks represent ownership in a business and are also referred to as shares. When we invest in a company’s stock, we are said to become stockholders or shareholders. We participate in the profits and losses of the company and ride the ups and downs of the stock’s price.

A stockholder is generally considered to own a minority stake in the corporation, which often comes with voting rights related to certain corporate governance matters. Becoming a shareholder, except in cases where a controlling interest is obtained, does not mean we have a say in the day-to-day operations of a business.

Remember, Bonds = Loans, Stocks = Owns

A key distinction between becoming a bondholder as compared to a stockholder is the concept of lending versus ownership. A bondholder essentially lends money to the bond issuer for an established period. The loaned money is referred to as the principal. The principal amount invested in the bond is returned when the period ends. A bond, like that gallon of milk in the grocery cooler, has an expiration date known as its maturity. Bond buyers agree to lend money to bond issuers for a period of days, months, or years.

Conversely, with stocks, there is no finite time period. After purchasing shares, the stockholder can choose when to sell the shares. Shareholders can hold stocks for many years or even generations as long-term investments. They can also be bought and sold in as little as one minute, as in the case of experienced day traders who enter and exit a stock position on the same day to make a quick profit.

Interest versus Dividends One thing bonds and stocks do have in common is that both can provide income, or cash payments, to their respective investors. The names and characteristics of these income payments, however, do differ.

Bonds provide the investor with interest payments that are paid periodically or factored into the principal sum. The bondholder sacrifices a principal amount for a given period and expects to be compensated for the risks involved. When a bond is offered to the market, the bond issuer specifies an interest rate in percentage terms. This outlines the amount and frequency of interest that the bondholder receives.

For example, the XYZ Corporation may issue a 5-year bond at a principal amount of $10,000 that pays a 4% annual interest rate quarterly. If we purchased this bond, we would fork over $10,000 and receive $400 annually (paid out in $100 quarterly increments) over the next five years. At the five-year mark, we would receive our final quarterly interest payment along with the return of our initial $10,000 investment.

Stocks can also generate income for investors. The income payments made by stock issuers to stockholders are called dividends. Dividends usually come from a company’s profits. Like bonds, the dividend payments often occur periodically, most often quarterly. But unlike bonds that have an obligation to pay interest based on the bond agreement, corporations can choose to increase, decrease, and even eliminate the dividend based upon company performance.

Dividends can also come in the form of stock dividends, rather than cash dividends. A company that chooses to distribute stock dividends to its stockholders gives additional shares in the company at a rate that is commensurate with the stockholder’s level of ownership. Not all companies offer dividends. Some choose to hang on to all their income to reinvest in the growth of the business.

Capital Preservation versus Capital Appreciation

Bonds and stocks typically serve different purposes in an investment portfolio. A bond investment is made to generate an income stream while protecting the value of the initial principal investment. As such, bonds are a means of capital preservation. They are best suited for investors who wish to preserve their funds and are content with a limited return on investment.

A stock investment is generally riskier than a bond investment and, on average, will do better over time. Stocks are a means to achieve capital appreciation. The stock buyer wants to see their investment grow over time in conjunction with the growth of the underlying company.

Bond and Stock Risk Differences

The notion of capital preservation versus capital appreciation goes hand in hand with a discussion of investment risk. It is important to remember that all investments, regardless of their perceived safety, carry some level of risk.

In the context of bond and stock investing, risk can be defined as the probability of loss or the fluctuation of an investment’s value. This fluctuation is also called volatility.

Stocks generally involve more risk than bonds. With most bonds, the investor pretty much knows how things will play out. The bondholder will receive periodic interest payments and a return of their principal at maturity. The daily fluctuations in bond prices are less of a concern unless it is traded for capital appreciation. The bond issuer is bound by the covenant made with the bond buyer and must make interest payments and return principal even if the business is struggling.

It possible however for a bond issuer to default on a bond payment if they enter bankruptcy. If this happens, the bondholder may receive a lesser amount than expected or may lose the principal entirely in a worst-case scenario. The risk of bond default varies by the type of bond issuer and the issuer’s financial strength. While losing money on bonds is possible, it occurs less frequently compared to other asset classes. Therefore, bonds are considered lower-risk investments.

Stocks are the other end of the risk spectrum. Shares have an inherently higher level of investment risk because a structured agreement does not bound them as with bonds. Stock prices move up or down based on company performance and outlook. It is not uncommon for a stock to move up or down by 5%, 10%, or more in a single day. On the flip side, a bond’s price may not move 5% for the whole year and are much less volatile.

Stocks are riskier because they are on the bottom of the totem pole in terms of their claim on a corporation’s assets. In the event of bankruptcy, lenders, i.e., bondholders, receive first dibs on any money the company can scrape together from the sale of assets like land and equipment. There are often various levels of bondholders, secured or unsecured, based on the presence of collateral. Common stock investors have the last claim on company assets after paying the lenders and bondholders.

What is the Average Return on Bonds? After getting a good grasp of what bonds and stocks are, many new investors want to know how much they can expect to make investing in bonds and stocks. There is no clear-cut answer to this question because historically, bonds and stocks have performed differently in various economic environments. And at the risk of sounding like the speed-talking disclaimer at the end of an investment advisor’s TV commercial, keep in mind that past performance does not predict future returns. But with this said, returns on bonds are typically lower than stock returns.

But bond returns are more consistent, meaning they do not vary as much from year to year. It is the relative stability of bonds that attracts some investors. These are often investors that are in or nearing retirement or that have lower risk tolerance.

According to a recent study by Vanguard, the U.S. bond market had an average annual return of 5.3% from 1926-2019. The best return year occurred in 1982, a 33% return, while the worst return year was an 8% decline in 1969. Bonds finished in negative territory in only 14 of those 94 years or 15% of the time.

Why Do Stocks Have Higher Returns?

The bright side for stock investors is that with higher risk, being paid last, often comes higher rewards in the form of higher returns. The term returns refers to the gain or profits made from an investment in dollar, or more commonly, percentage terms.

We’ve learned that there is a direct relationship between risk and return. Stocks offer more significant potential for increasing value as compared to bonds because they involve higher risk. Stock investors require a higher rate of return based on the risk of equities in general and the risk of the individual company.

For instance, we expect higher volatility and potential returns from money-losing technology companies compared to a more mature, low-risk consumer staples company. When a company exceeds expectations, the stock price goes up, and stockholders are happy. When a company underperforms, investors deem that the company is not worth the risk, and the stock price goes down.

Over the long-term, stocks have provided higher returns to investors than bonds. The Vanguard study also showed that the average annual return on U.S. stocks from 1926-2019 was 10.3%. As we’d expect, with that higher return has come higher variability. The best year was a 54% surge in 1933, and the worst year was a 43% plunge in 1931. In 2019, the stock market, as defined by the S&P 500 index, advanced 29%. Stocks suffered a loss in 26 of the 94 years or 28% of the time. This goes to show that despite finishing down more than a quarter of the time, U.S. stocks have generated a 10% annualized return in route to setting record highs.

S&P 500 Historical Annual Returns (1927-Present)

S&P 500 Historial Annual Returns 1927-Present Source: Macrotrends.net

Asset Allocation: How Much Should I Have in Bonds?

So, we know that bonds are for relative safety and income, while stocks equate to risk-bearing growth. But how do we go about deciding which one is best for our situation? This brings us into the concept of asset allocation. Asset allocation is the process of how to divvy up your investment dollars into bonds, stocks, and other investments.

While some circumstances may dictate that a 100% bond or 100% stock portfolio is appropriate, often a mix of both is prudent. Many factors go into building a bond-stock portfolio, including investment purpose, time horizon, financial flexibility, and liquidity needs. For now, let’s generalize these factors as one combined measure of risk.

An investor’s risk level is a combination of the ability to incur risk and the willingness to take on risk. The ability relates to one’s financial situation, and the willingness is more about the personality of the investor. There can be many reasons to limit or take on risk. Most importantly, an investor’s risk level should be consistent with their asset allocation choices.

For example, a low-risk, conservative investor would be better suited with an 80% bonds/20% stock asset allocation. A 20% bonds/80% stocks portfolio would match the profile of a high-risk, aggressive investor. As investors, our asset allocation pie is not a fixed thing; it can vary over time as our financial needs and circumstances evolve.

Should You Buy Bonds in a Recession?

With the stock market near all-time highs and frequent market chatter about whether a recession is looming, many investors are wondering if they should be buying bonds rather than stocks. A recession is a period of decline in economic activity more precisely defined as two consecutive quarters of negative gross domestic product (GDP) growth.

Investing in bonds can be a good way to lock-in stock market profits and protect wealth regardless of whether a recession comes. But it can be a particularly smart move in a confirmed recession. This is because a recessionary period marked by a slowdown in business activity means corporations are earning less. This can reduce the value of companies’ stocks and lead to a downturn in the overall stock market. Stocks and bonds are often negatively correlated. This means when stocks go up, bonds go down and vice versa.

Bonds can play the role of protector by limiting a downward move in your portfolio value. This scenario reinforces the importance of diversifying an asset allocation by including both bonds and stocks. The bond allocation of a portfolio can help soften the blow during a dip in the stock market. This doesn’t necessarily mean that we should instantly go 100% into bonds. There are also many excellent stocks to consider in a recession. A non-cyclical food and beverage company that has a long track record of enduring recessions is an example of a good stock to own.

Trading Aspects of Bonds and Stocks

We know that stocks trade in the form of shares on the major stock exchanges such as the New York Stock Exchange or Nasdaq Stock Exchange. But what about bonds? While many investors purchase bonds with the intent of earning interest and holding on until maturity, bonds can also be actively bought and sold in the bond market. Bonds do not trade in shares, though. Instead, they trade in specific dollar amounts.

An investor may choose to sell a bond before its maturity date if they need to liquidate the security due to an unforeseen emergency, or if they prefer to rotate the funds into a more attractive bond or into stocks. With stocks, an investor’s choice to sell all or some of a company’s shares may be based on a similar need for liquidity, a decision to take profits off the table, or a decision to cut losses.

Stocks vs. Bonds vs. Gold Over Time Visualization

The Recap

Stocks and bonds are a way for companies and governments to raise capital. Stocks are riskier than bonds because bondholders have a claim on a company’s assets before stockholders. Since stocks are riskier, they generally have a higher return than bonds. Most investors should consider a mixed portfolio of bonds and stocks. Sophisticated traders can utilize bonds to secure a profit or protect gains in the likelihood of an earnings downturn or recession as stocks and bonds are often negatively correlated.

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Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.