Bonds vs. Stocks: What’s the Difference?

Posted by Frank Gogol
Updated on April 28, 2022

So, you’re thinking of investing your money. You have heard a lot of people argue about bonds vs. stocks. You know your investment portfolio should be balanced, but what exactly is the difference between stocks and bonds?

Below we take a look at the pros and cons of bonds vs. stocks to help you decide what to invest in.

Difference Between Stocks and Bonds?

The difference between bonds vs. stocks are questions any investor will ask about their portfolio. The difference between stocks and bonds is that a stock is a form of ownership, whereas a bond is a type of loan.

What is a Stock?

When you buy a stock, you are buying a tiny piece of a company – one or more “shares” in that company. When you buy stocks, you own a bit of the company. 

Companies issue shares to the public for many reasons. One of the most common reasons to issue shares is to raise cash that can be used to help the company grow.

If the company does well, it will grow in value. This means your tiny piece of the company, your share, also grows in value as the stock price of the company increases. You could even sell your shares to another investor for a profit.  

If the company does badly, it will lose value. If the value of your share falls below what you bought it for, you would sell them to another investor at a loss.

Stocks represent partial ownership, or equity, in a company. When you buy stock, you’re purchasing a tiny slice of the company — one or more “shares.” And the more shares you buy, the more of the company you own. Let’s say a company has a stock price of $50 per share, and you invest $2,500. That’s 50 shares for $50 each.

What is a Bond?

A bond, on the other hand, does not involve buying pieces of a company. When you buy a bond, you do not become a part-owner.

When you “buy” a bond, you are agreeing to loan some of your money to the company or government issuing the bond. The company or government is in debt to you when you buy a bond. They will pay you interest on the loan (bond) for a set period. After that, you will be paid back the full amount you bought the bond for.

The duration of the bond can be anywhere from a few days to 30 years. The interest rate, known as the yield, will vary depending on the type and duration of the bond.

What’s the Difference?

In bonds vs. stocks, the biggest difference is in the valuation. Stocks offer higher risk and reward than bonds do.

Stocks gain their value based on the supply and demand in the stock market. The value of your tiny piece of the company depends on the volatile stock market. It can grow a lot, or it can decrease in value. 

With bonds, you usually know exactly what you are signing up for. The value of a bond is predetermined and can be used as a source of predictable income over long periods. This doesn’t mean that a bond is without risk, but it is less volatile than the stock market.

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Comparing Stocks and Bonds

Stocks and bonds are very different investment instruments. They generate cash in different ways and they tend to have an inverse performance relationship.

Debt vs. Equity

Bond vs. Stocks is the same as Debt vs. Equity. A bond (debt) is a way to make money off other people owing you money. Equity is an asset that you own. 

Buying bonds means issuing a debt that must be repaid with interest. You agree that the company or government will pay you fixed interest over time. The principal amount will also be repaid to you at the end of the period.

When a company offers stocks for sale, we say that they are issuing equity. Investors are allowed to benefit from the future growth and success of the company.

Capital Gains vs. Fixed Income

Stocks and bonds generate cash in different ways.

To make money from stocks, you need to sell your stocks at a higher price than you paid for them. This profit is called a capital gain. You can use your capital gains however you want – as income you want to use, or to be reinvested. You will be taxed on your capital gains.

Bonds produce cash for you from the interest payments on the loan. These interest payments can happen semiannually, quarterly, monthly, or at maturity. The value is that the cash generated will be predictable. Bonds can also be sold on the market for capital gain, but that is not the main purpose of this financial instrument.

Inverse Performance

Although this is not a hard and fast rule, it tends to be true that when stock prices rise, bond prices fall, and vice versa. 

When stock prices rise, investors buy stocks to capitalize on that growth. Then there is a lower demand for bonds. Conversely, when the stock market is going down, investors turn to the lower-risk, lower-return investments like bonds.

In a balanced investment portfolio, you will tend to have both bonds and stocks. This allows you to spread your risk. When your stocks perform poorly, your bonds will usually perform well, and vice versa.

Risks and Rewards

As with most investments, the bigger the risk you take as the investor, the higher your chances of reward. If the risk doesn’t pay off, you could make a loss. A low-risk investment might not give you big rewards, but the chances of you making a loss is also much lower.

Stock Risks

The biggest risk with stock investments is that the company you chose is unsuccessful and the stock price goes down. When you choose to sell, you might make a loss.

Most stocks are not like that. The risk of buying stocks tends to lie in stock market price fluctuations. If you don’t have a timeline on when to liquidate your stocks, the market fluctuations carry less risk. The value of your stock will go up and down. You need to sell when you think the stock is at its high point. 

Bond Risks

In bonds vs. stocks, bonds are generally less risky. The interest payments on your bond investment are very stable and secure. But the interest payments are also typically lower than the average return on the stock market.

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Conclusion

Stocks are equity. You own a bit of a company. You make your money by selling your bit of the company for a profit. This means you might get a big reward, but it is riskier.

Bonds are a loan. You lend your money to a company or government. You make your money through the interest payments made on the loan. This means you get a small reward, but it is very low-risk.

A balanced portfolio will include both of these instruments to evenly spread your risk.


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