Personal finance for young adults: Stocks vs. bonds
Author: Halsey Schreier
Are you ready to learn about the basics and start investing? Do you want to know the difference between a stock and a bond?
You’ve probably heard of stocks and bonds. Both are essential building blocks of most investment portfolios and are often mentioned in the same breath. Stocks and bonds are two types of investments that can help you grow your money—but how they do it and the returns they offer can be very different.
What exactly is a stock?
A stock is a unit that represents an ownership share in a company. When you purchase stock, you own a small piece of the company that issues it. Stocks are also commonly referred to as shares or equity.
Companies issue stock to raise capital for a number of reasons; to grow the business, pay off debt, fund new products or product lines, expand operations, or enter into new markets or regions.
Most investors own what’s called common stock, which allows them to participate in a company’s growth and profitability. However, owning stock doesn’t mean you own the actual company, but rather you own shares issued by the company.
Owning common stock entitles you the right to vote at shareholder meetings, receive dividends, and sell your shares.
Why buy stocks?
Most people buy stocks for the opportunity to build wealth—either through capital appreciation or dividend payments. Another reason to invest in stocks is to exercise influence over the company through voting rights.
Types of stocks
There are many different types of stocks. Stocks are often grouped together based on their style characteristics:
Growth stocks. These are companies that are generally growing at a faster rate than the market. Growth companies rarely pay dividends and investors will buy these stocks for their growth potential.
Income stocks. These are companies that pay consistent dividends and thus provide a reliable income stream. An established utility company is an example of a company that is likely to be an income stock.
Value stocks. These are undervalued companies that may have fallen out of favor or have been overlooked by the market. Investors purchase value stocks with the belief that the stock price will rebound.
It is also possible to categorize stocks by market capitalization, geographic location, and rights granted to the holder of the stock.
Stocks may lose value
Stock prices fluctuate throughout the day. While most investors own stock because they believe it will increase in value, not every stock does. It is possible for stock investors to lose all or part of their investment if a company loses value or goes out of business.
A stock’s price can be affected by company-specific factors, such as a faulty product or poor management, or by circumstances that the company has no control over, such as geopolitical or economic and market events.
What is a bond?
Bonds are debt instruments issued by governments and corporations when they want to raise money. When you buy a bond, you are essentially loaning the issuer money. In return, you will receive interest on the loan for a set period of time, called a coupon rate, and after that period you will receive the full amount you initially paid for the bond.
Why invest in bonds?
People generally invest in bonds as a way to generate income and to help offset volatility resulting from owning stocks.
If you buy a bond, you can simply collect the interest payments until the bond reaches maturity—the date the issuer has agreed to pay back the bond’s face value. You may also buy and sell bonds on the secondary market. After a bond is issued, the coupon rate will remain the same, but the price will fluctuate.
Types of bonds
Government bonds. Government bonds are considered among the safest types of investments. As a result, interest rates offered on government bonds are generally low.
Corporate bonds. Companies will issue corporate bonds when they need to raise money. For example, a company may issue a bond if it wants to build a new plant.
High-yield corporate bonds will offer higher interest rates in exchange for a higher level of risk. Investment-grade bonds on the other hand are generally lower risk and will offer lower interest rates.
Municipal bonds. Municipal bonds are issued by states, cities, counties and other nonfederal entities to fund state or city projects like building schools or highways.
Interest on municipal bonds is generally exempt from federal and state and local taxes if they’re issued by the state or city where you live.
Pros and cons of bond investing
Adding bonds to your investment portfolio can help diversify your assets and lower your overall risk. Unfortunately, that often means you’ll receive a lower rate of return.
Bonds are also subject to default risk, the risk that an issuer will be unable to make its interest payments and repay the principal loan amount. Credit quality is a measure of an issuer’s creditworthiness or likelihood to default.
In addition, there is also the chance that you’ll have difficulty selling a bond, particularly if interest rates go up. Inflation can also reduce your purchasing power, making the fixed income you receive from the bond less valuable over time.
Also, bond prices often go down when interest rates rise and so do the coupon rates on new bonds. Because the higher coupon rate is more attractive, the resale value of older bonds offering lower interest rates is diminished.