Stocks vs Bonds: What You Need to Know

phone showing movement of stocks and bond in market

Even if you're new to investing, chances are you've heard of stocks and bonds. Both are securities that can be bought and sold to net potential investment returns and grow your wealth, but they work very differently. When you buy shares of stock, you own a small piece of the company that issued it. With bonds, you're loaning money to a company or group that promises to repay you with interest.

Both stocks and bonds have their place in a balanced investment portfolio—and understanding how they work can help you make more informed investment decisions that support your long-term financial goals.

What Are Stocks?

Stock shares are sold by public companies as a way of raising capital. In exchange, shareholders have an ownership stake in the company. Stocks can be profitable if you buy low and sell high, but they present a lot of risk. The stock market is known for its unpredictability, and prices can swing wildly from one extreme to another. Accurately predicting the future value of a stock is anyone's guess.

Having said that, there are two main categories of stocks:

  • Common stock: If you own this type of stock, you're entitled to vote at shareholder meetings. You may also receive stock dividend payments, which are recurring payouts the company doles out as a way of sharing some of its profits. Dividends are typically offered by mature companies that are on solid financial ground.
  • Preferred stock: This type of investment is like a mix between a common stock and a bond. Shareholders typically do not have voting rights, but they do receive preferred dividends, usually in fixed amounts. Those with preferred stock will be paid out ahead of investors who hold common stock.

A company's size can also be used to categorize its stock. A company's market capitalization (or market cap) refers to the total value of its outstanding stock shares. Below is a breakdown, according to the Financial Industry Regulatory Authority:

  • Large-cap stock: $10 billion or more
  • Mid-cap stock: Between $2 billion and $10 billion
  • Small-cap stock: Between $250 million and $2 billion
  • Micro-cap stock: Less than $250 million

There are also penny stocks, which generally trade at less than $5 per share. They're seen as especially risky and usually aren't considered a wise investment.

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How Do I Make Money With Stocks?

If you sell your shares after stock prices go up, you'll turn a profit. This is called a capital gain, which is taxable. (Your income and how long you held the stock will determine your tax liability.) But if share prices go down, you could lose money if its value never again exceeds what you paid for it. This is precisely why stock investing is fundamentally risky.

Investors who are looking to dip their toes in stock investing might consider buying fractional shares instead of buying a full share. Because you'll only own a percentage of a stock, you can benefit from gains (albeit to a lesser degree) while minimizing losses.

As mentioned earlier, dividends are another way investors can make money with stock. They're most commonly delivered as a cash payment that goes directly to your investment account. Alternatively, some companies might provide dividends in the form of stocks, which translates to greater appreciation and extra dividends over the long haul.

How Do I Buy Stocks?

If you feel ready to start investing, you can see if your employer offers a 401(k). It's a great way to invest in stocks, build your nest egg and score some attractive tax benefits along the way. An individual retirement account (IRA) is another long-term investment vehicle.

You can also open a brokerage account to purchase individual stocks. Fidelity, Vanguard and Charles Schwab are popular firms, but there are lots to choose from. Comparing fees, investment options and resources can help you find the right brokerage for you. You can then transfer funds directly to your account to begin buying stock shares. Popular individual stock exchanges include the Nasdaq and the New York Stock Exchange.

The question then becomes what to buy. Purchasing individual stock, either on your own or through a broker, is one option. However, it's impossible to predict which stocks will soar and which will flop, which is why individual stock picking is especially risky.

Mutual funds can be a good alternative. They're pools of investments that include small shares of different types of securities. Their structure provides some diversification and can help offset potential losses. Some mutual funds follow popular market indexes, like the S&P 500.

Exchange-traded funds (ETFs) provide a little more flexibility. They work like indexed mutual funds but their prices go up and down with supply and demand. They're also traded daily like stocks.

What Are Bonds?

The bond market works quite differently from the stock market. When you purchase a bond, that money is used to fund the corporation or government entity that issued it. The bondholder is eventually repaid the principal amount plus interest.

Bonds are generally much less volatile when compared with stocks, and returns are often much lower. With a bond, you might receive your funds all at once upon the maturity date or get periodic interest payments beforehand.

The most common types of bonds include:

  • Corporate bonds: These bonds are issued by public and private corporations. High-yield bonds come from issuers that have a lower credit rating and, in turn, offer higher interest rates to make up for the added risk.
  • Municipal bonds: These are commonly issued by local governments (states, cities and counties).
  • U.S. Treasury securities: Treasury securities—bonds, notes and bills—are issued by the U.S. Department of the Treasury and backed by the federal government.

How Do I Make Money With Bonds?

If all goes well, the bondholder will recoup their investment and turn a profit with the interest. But just like stocks, nothing is ever guaranteed. There's always the chance that the bond issuer will default. Issuers with stronger credit ratings typically offer lower interest rates—and the opposite also tends to be true because a lower credit rating suggests a greater risk that you'll lose money.

Inflation presents its own risk because it reduces your investment's purchasing power. If you have a fixed-rate bond with a long maturity date, the return on that investment may not go as far in the long run. Bonds can still provide some diversification in your investment portfolio and help mitigate risk, but they're viewed as a conservative investment. They may be more attractive than high-risk investments as you get closer to retirement. An added perk is that some government bonds also provide tax benefits.

How Do I Buy Bonds?

You can connect with a broker to purchase individual bonds from a corporation or government agency. (Unlike stocks, you can't buy fractional shares of bonds, so you'll need enough cash on hand to complete the transaction.) You may also be able to buy bonds directly from the issuer. While this can be tricky with corporate bonds during a primary bond offering, some municipal and Treasury bonds are available for purchase at without an intermediary.

Another option is to look into an ETF or mutual fund that specializes in bonds. Just know that fees are common, so be sure to compare funds before going all in.

Stocks vs. Bonds: Which Investment Is Better?

Stocks and bonds don't have to be an either/or situation for investors. Instead, it's wise to have a mix of both high-risk and low-risk investments in your portfolio. Diversification creates balance. If one investment type or industry in your portfolio takes a hit, the hope is that other sections will be doing well enough to pick up the slack.

With that said, stock investing is a riskier endeavor. There's built-in uncertainty and market volatility, so investors are more vulnerable to losses. On the flip side, stocks also create a greater opportunity for growth. Historically, the stock market has produced an average annual return of about 10%. The farther away you are from retirement, the more risk you may be comfortable assuming in your investment portfolio.

The Bottom Line

When it comes to stocks versus bonds, one isn't necessarily better than the other. Investing is all about getting your money to work a little harder for you. It's also a key part of long-term financial health. The same can be said about your credit score and credit report. Free credit monitoring with Experian keeps you informed and helps minimize unwanted financial surprises.