Understanding the Distinctions Between Bonds and Stocks
Everyone aims to enhance their lifestyle and that of their loved ones by accumulating wealth. Many individuals find purchasing a business or real estate challenging. A viable alternative is channeling some of your income towards investments such as stocks and bonds. Over the years, investing in stocks and bonds has proven to be an effective method of building wealth.
According to data from Vanguard, a well-balanced portfolio comprising 60% stocks and 40% bonds delivered an impressive 6.8% annualized return over the past decade until September 2024. This might appear modest, but it leads to a doubling of your money every decade, with less volatility than a stock-only portfolio.
This article aims to demystify stocks and bonds, their differences, and how they can help grow and protect your wealth. Let's dive right in!
Stocks
What are stocks?
Stocks are essentially shares of a company's ownership. Buying stock in a company means you become a partial owner. A company's success or decline in value directly impacts the value of your shares.
Making money with stocks
The key strategy to make money with stocks is investing in high-quality companies at fair prices and then holding onto them for years. The primary factor influencing stock performance over time is the company's earnings per share (EPS) growth. Greater profitability often equates to a more valuable stock.
Stocks can also be an excellent source of income through dividends, specifically for more mature companies that generate excess cash. Lastly, options offer another avenue for investors, involving contracts to buy or sell shares of a stock at a predetermined price in the future.
Types of stocks
Common stock grants you ownership rights and voting power at the company's annual shareholder meeting. Some businesses may issue multiple stock classes with varying voting rights.
Preferred stock, on the other hand, is more akin to a bond. It provides a fixed dividend and tends to preserve value with limited upside.
Pros and cons of stocks
Pros:
- Unlimited upside depends on company's EPS growth
- Accessible to most investors
- Proven long-term wealth generator
Cons:* Risk of permanent losses if company struggles or fails* Volatility leading to losses when held in the short term* Emotional challenges in holding through stock downturns
How to buy stocks
Purchasing stocks has never been easier, thanks to reputable online brokers offering low-cost or no-cost trades and different account types customized to individual needs. Many brokers also offer fractional investing, letting you buy less than one full share of a company.
Bonds
What are bonds?
Unlike stocks, bonds represent loans to a company or government. Bondholders receive a set interest payment and repayment of the bond's face value at maturity.
Making money with bonds
Bonds generate income through yield. However, bond prices may fluctuate depending on interest rates, affecting profits when selling before maturity.
Types of bonds
Treasury bonds, notes, and bills, issued by the US government, range from a few weeks to 30 years before maturity and are considered one of the safest bonds in existence.
Municipal and corporate bonds, on the other hand, present varying levels of risk depending on the issuer's financial strength.
Pros and cons of bonds
Pros:
- Low-volatility source of income
- Lower risk of permanent losses than stocks
- Higher yield than savings, protecting value against inflation
- Potential value increases if interest rates fall
Cons:
- Vulnerable to losses if borrower fails to make payments or repay bonds at maturity
- Risk of loss if sold before maturity in a high-interest-rate environment
- Historically underperformed stocks as a long-term investment
How to buy bonds
Most online brokers support buying and selling corporate and municipal bonds on the secondary market, in addition to bond mutual funds or exchange-traded funds (ETFs). Treasury securities can be directly purchased through the Treasury Direct website.
Whether stocks or bonds are the right investment for you depends on your financial goals and the time frame for achieving them. Stocks generally yield higher returns in the long term but have greater volatility, while bonds are a stable source of income with lower risk and returns.
[1] Source: Vanguard Investment Strategy Group[2] Source: J.P. Morgan Asset Management[3] Source: Morningstar Direct[4] Source: Vanguard Investment Strategy Group
In the context of managing wealth, investing in a balanced portfolio of stocks and bonds can deliver steady returns over time, as demonstrated by Vanguard's 60/40 portfolio, which showed an annualized return of 6.8% from 2014 to 2024, leading to a doubling of money every decade with less volatility compared to a stock-only portfolio.
Purchasing bonds, particularly treasury bonds, municipal bonds, and corporate bonds, represents a loan to a company or government and offers lower risk than stocks, generating income through yield while providing a hedge against inflation.
