What’s the difference between stocks and bonds?

Stocks and bonds are often considered key components of many financial plans. Stocks offer partial ownership in a company, while bonds typically involve lending money to a government or company in exchange for interest payments. Knowing how each one works and how they balance each other can help you build a portfolio that aims to navigate market volatility.

Here’s everything you need to know about stocks, bonds and how they differ. 

What’s a stock?

A stock, also known as a share or equity, represents partial ownership in a corporation's assets and earnings. Generally, the more shares you own, the larger your ownership stake in the business. Companies typically sell stock to raise money to grow their business, pay down debt, expand operations or enter new markets.

Historically, stocks have been one of the most effective ways to grow wealth over time. While prices can fluctuate in the short term, investors often use stocks to help their savings outpace inflation and pursue long-term growth. This is mainly done through share price gains and/or dividends. Dividends include periodic payments made by the company to shareholders from the business’ earnings if the company decides to distribute a portion of its profits.

How do stocks work?

You can make money from stocks in different ways. One common approach is selling shares at a higher price than you originally paid, also known as a capital gain. Stock prices move up and down based on what investors believe a company is worth. Earnings, growth expectations and economic conditions can influence the demand for a stock. If more people want to own shares in the business, the price may rise and vice versa.

There are different types of stocks that drive the market and the value of shares. Some include:

• Growth stocks: Shares in businesses that are expected to grow their earnings faster than the broader market. While they can offer strong growth potential, stock prices tend to be more sensitive to market volatility.
• Value stocks: Shares in companies that appear undervalued based on their fundamentals, such as earnings, book value or cash flow. Investors may believe these companies are temporarily undervalued and will have potential gains over time.
• Dividend stocks: Shares of companies that regularly return a portion of their earnings to shareholders. Dividends are often paid out quarterly, but they can also be paid monthly, semi-annually or annually. Occasionally, a company may issue a special dividend, which is a one-time payment and often triggered by unique events.

Here’s an example of how an investment can grow over time: Say a company has a stock price of $100 per share, and you invest $1,000 (10 shares for $100 each). The business performs well over the next five years, and its stock price moves up to $150 a share. Your investment would grow to $1,500, meaning you’ve earned a $500 profit if you sell. Note: this example doesn’t take into consideration any fees, commissions or taxes.

What does market cap mean?

You can buy stocks according to market capitalization (market cap), which is a way to determine the size of a business. Market cap can be calculated by multiplying a company’s current share price by the number of outstanding shares, which is the total held by all a company’s shareholders, including institutional investors and company officers. It can be a useful tool for gauging a company’s size, risk profile and growth potential.

Companies are typically grouped into the following categories:

• Micro-cap stocks include companies in the early stages of development that may have significant room to grow.
• Small-cap stocks can offer higher growth potential but are often considered higher risk investments.
• Mid-cap stocks offer a middle ground to the risks and rewards of their smaller and larger counterparts.
• Large-cap stocks usually refer to companies with significant market capitalizations and established business operations. These companies tend to have more consistent performance, lower volatility and sometimes regular dividend payments.

Market capitalization can help provide insights into a company's risk and growth potential. Smaller companies may have more room to grow but can experience larger price swings, while larger companies are often more established and may offer greater stability. Including a mix of market caps in your portfolio can help you benefit from different stages of business growth and risk levels. Fidelity offers a wide range of market cap funds:

What’s a bond?

When you buy a bond, you’re often lending money to the issuer, typically a government, corporation or other institution, for a specific period. In exchange, the issuer pays you interest on the principal over a fixed term, which can range from three months (for example, three-month treasury bills) to 30 years (for example, 30-year Government of Canada bonds).

Bonds are generally considered lower risk investments compared to stocks because they offer more predictable returns and are often issued by stable entities like governments. However, this lower risk primarily applies to government bonds, which have minimal default risk. Corporate bonds can carry significant credit risk. If a company experiences financial difficulty, bondholders are generally prioritized over equity holders when it comes to repayment.

You may use bonds to help reduce portfolio volatility, generate income and preserve capital. While bonds generally offer lower growth potential than stocks, they can provide greater stability during periods of market uncertainty.

What types of bonds are there?

Bonds come in a variety of options, with government and corporate bonds being the most common types:

• Government bonds: Issued by national governments, such as Government of Canada Bonds or U.S. Treasuries. They’re typically lower risk because these governments tend to have stronger financial stability, reducing the likelihood of default.
• Provincial bonds: Historically, provincial governments have been able to generate steady revenues from taxes and other resources, reducing the risk of default.
• Corporate bonds: Companies of various sizes may issue bonds to support their business operations. Pay attention to the credit rating on a corporate bond. The rating indicates its creditworthiness or the likelihood the company could default.

Bonds can also be categorized according to their features, such as risk level, maturity or interest payments. Fixed-rate bonds pay out a consistent rate over their term, while floating-rate bonds come with rates that move up or down as a benchmark interest rate, like the Bank of Canada’s overnight rate.

How do bonds work?

When a bond is due (or reaches its maturity date), the issuer must pay back the principal amount in full. The return you earn from holding the bond until its maturity is known as yield-to-maturity (YTM), or simply, yield. Generally, YTM represents the total return you could earn if you hold a bond until maturity and receive all interest payments as expected.

The interest you earn on the bond every year is based on the coupon rate and face value. The face value is the amount the issuer agrees to repay the bondholder at maturity, while the coupon rate is a fixed percentage of that face value, determining the annual interest payment.

Here’s an example: Let’s say you buy a Government of Canada bond for $1,000. You hold the bond until it matures in 10 years, and it pays a coupon rate of 4%. This means:

• You’ll receive $40 in interest each year.
• Over 10 years, you’ll collect $400 in total interest payments.
• When the bond matures, you’ll also get your $1,000 principal back.

The bottom line

There's no one-size-fits-all mix of stocks and bonds. The right balance depends on your goals, investment timeline and comfort with risk. Understanding how each investment works is an important first step toward building a portfolio that aligns with your needs. Consider talking to a financial advisor to help you determine the right asset mix for your portfolio.

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