Investing in Bonds vs Stocks
Whether you're new to investing or an experienced money maker, it never hurts to weigh new options for building the perfect portfolio. As two of the most traded types of assets, stocks and bonds are the heartbeat of Wallstreet that keep financial freedom in vogue. To get you and your money growing in the right direction, this article will explain the difference between investing in bonds vs stocks and which one you should choose.
Table of Contents
Investing in Bonds vs Stocks
What are bonds?
A bond is an investment that works like a loan. Think of bonds as an IOU agreement between a lender (bondholder) and a borrower (bond issuer) that includes the details of the loan and its payments. In simple terms, one party lends money to another party that needs money with the promise that the loan will be paid back with interest.
Instead of going to a bank, a company or government organization will issue bonds to get money from investors, otherwise known as lenders. In exchange for the capital, the bond issuer makes interest payments called “coupons” to the lender over the lifetime of the bond. When the bond reaches its end (the maturity date), the issuer pays the principle—initial investment—back to investors.
Bonds vs Bond ETFs
When you buy a bond, you essentially lend your money to a single entity for a fixed period of time. When that time is up, the issuer repays the bond in full. Bonds are categorized by the entity that issues them, the most common being government, corporate, municipal, and foreign bonds. Depending on the type of bond, buying and selling on the secondary market isn’t the easiest undertaking for the average investor.
With bond ETFs, you are buying a collection of bonds from multiple entities for one price. Like index-based or industry-based exchanged-traded funds (ETFs), bond ETFs trade on an exchange like a stock. Think of bond ETFs like a basket that holds dozens or hundreds of bonds without having to select them individually.
While both have similarities, bond ETFs typically offer better risk-adjusted returns at a lower cost than buying individual bonds. Another benefit of bond ETFs is that they pay interest on a monthly schedule compared to bonds that pay interest on an annual or semi-annual schedule. However, bond ETFs never mature. If bond ETF prices are falling, you may see declines in your investment. In other words, you aren’t guaranteed to get your money back at some point in the future like you are with individual bonds. The price may fluctuate while you hold an individual bond, but you can receive 100% of your initial investment when it matures.
What are stocks?
Stocks represent shares of a company. When a company issues stock, it’s selling tiny pieces of itself in exchange for cash. And anyone can buy those pieces to claim a percentage of the company’s assets and earnings. This percentage depends on how many shares you own compared to how many currently exist (the “outstanding”). Let’s say you own 100 shares of a company with 5 million outstanding shares. With some simple division, you own .00002 percent of the company. In a nutshell, the more shares you buy, the more of the company you own.
When a company first issues shares, they often do so through a process called an initial public offering or IPO. Once the shares are sold for the first time in the “primary market”, stockholders (the person buying shares) can resell them in the “secondary market”, also known more commonly as the stock market. Like any other free market, the stock market operates on the laws of supply and demand. Excess demand will drive stock prices up, and excess supply will push stock prices down.
The Difference Between Investing in Bonds vs Stocks
Stocks and bonds both provide ways to invest your money. When you buy a stock, you are purchasing a piece of a company. When you buy a bond, you are loaning money to a company or government organization.
Equity vs Debt
Stocks are simply ownership shares of corporations. The stockholder is entitled to a portion of the company’s assets and profits equal to how much stock they own. That’s why stock is also referred to as “equity”. When a company in the stock market makes money, everyone who owns a piece of that company profits too.
Bonds represent debt. There’s no equity involved or any shares to buy. Bondholders essentially act as a bank by lending money for a set period of time and charging interest. Just like a bank loan, a bond includes terms for repayment and interest installments.
Stocks and bonds tend to have an inverse relationship in terms of price. Generally, when stock prices rise, bond prices fall due to lower demand. In contrast, when stock prices fall because investors are looking to minimize risk, demand for bonds increases, driving prices up.
Bond performance is also inversely correlated with interest rates. When interest rates go up, bond prices fall, and vice-versa. For example, suppose you buy a bond with a 3% yield, and then the interest rates drop to 2%. In this case, your bond could become more valuable because newly issued bonds would have a lower yield.
Capital Gains vs Fixed Income
Stocks and bonds generate income in different ways. Bonds provide investors with a fixed income stream through regular interest payments. The frequency can vary based on the type of bond, but interest is typically paid twice a year. To make money from stocks, you need to sell your shares at a higher price than what you bought them for. The profit generated from selling stocks is called capital gains, which can be used as income or reinvested. Capital gains can be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes.
Bonds can also be sold on the market for capital gains if their value increases higher than what you originally paid. If you purchased a bond at a discount, you will have to pay capital gains tax on the difference between the price you paid and the bond’s par value. The par value is the amount of money that bond issuers agree to repay to the bondholder.
Bonds Pros & Cons
While bonds lack the long-term return potential of stocks, they are considered to be less risky. Below we will review the pros and cons of investing in bonds.
Pros: The Good Stuff
Fixed Income: Bondholders can earn a fixed income with regular interest (or coupon) payments.
Less Risk: Bonds are a relatively safe investment and even offer risk-free options for bonds issued by the U.S. Treasury.
Capital Preservation: A fancy term for never losing your principal investment if you hold on to the bond until its maturity date.
Cons: The Not So Good Stuff
Lower Returns: Higher credit rating, lower risk, lower returns. Long-term government bonds earn around 5% in annual returns, while the stock market historically yields 10% in average annual returns.
Interest Rates: When interest rates change significantly from what the investor expected, there is a risk of prepayment or getting stuck with a bond yield below market rates.
Payment Default: This refers to the bond issuer failing to make interest payments, leaving itself open to default on repaying the bond upon maturity.
Stocks Pros & Cons
The stock market has historically delivered generous returns to investors over time. But what goes up must come down, presenting investors with the potential for significant profits and losses. Let's look at some of the pros and cons of investing in stocks.
Pros: The Good Stuff
Company Shares: Owning stock entitles you to vote in shareholder meetings, collect dividends (company profits), and sell your shares to somebody else.
Higher Returns: The S&P has a mean return of 11.4% and compound annual growth of 9.5% since 1927, indicating that the stock market has provided good returns over the long haul.
Unmatched Liquidity: Investors can easily access money in the stock market. Within seconds, investors can buy, sell, trade, or convert stocks into cash.
Cons: The Not So Good Stuff
Financial Literacy: New investors tend to buy high out of greed and sell low out of fear. To make informed trades, learn how to read financial statements and annual reports, and follow your company's development in the news.
More Risk: If a company does poorly, investors will sell, driving the stock price down. When you sell, you could lose your initial investment.
Market Crashes: While large failures in the system aren't common, they do happen, and it can take years to recover. Potential investors can look back to 2008 to see how badly the market can crash in a matter of hours.
Where Should You Invest: Bonds vs Stocks
The main reason people invest in stocks is the prospect of price appreciation on shares. The main reason people invest in bonds is the virtual guarantee repayment on the initial investment with interest. When it comes to choosing between bonds vs stocks to invest your hard-earned money, there is no one correct answer. For most investors, a combination of stocks and bonds is the best way to diversify and add stability to a portfolio. A balanced strategy leverages the relative safety of the bonds with the higher return potential of stocks.
Before you start building a portfolio, you should consider how involved you want to be in the investing process. If you're actively investing, you will typically use an online brokerage to try and beat the market with your trades. This method requires a ton of time and research. If you want to be less hands-on, you can try passive investing, where you buy a chunk of the market and ride the ups and downs over a long period. Alternatively, you can hand the reigns over to a financial planner or robo-advisor to handle your investments.
Bonds vs Stocks vs Mutual Funds
Individual securities are exactly what the name implies—buying a stock or bond from a specific entity. You know exactly what you own, and there are no ongoing fees or management expenses. In a mutual fund, investors pool their money to buy a collection (also called shares) of securities like stocks, bonds, and other assets. When you buy shares in a mutual fund, you don’t actually own the shares, you own a piece of the fund. Each investor, therefore, participates in the gains or losses
Mutual funds are professionally managed by financial advisors who allocate the fund’s assets and attempt to produce capital gains or income for investors. The value of a mutual fund depends on the performance of the securities in its portfolio. So, when you buy shares of a mutual fund, you are purchasing a part of the portfolio’s value. The share price of a mutual fund is called the net asset value (NAV). The NAV is calculated by dividing the total value of the assets in the fund’s portfolio by the number of outstanding shares.
Where To Buy Bonds & Stocks
Now that you know a thing or two about bonds vs stocks, it's time to invest your money. You can do this online or through a financial advisor (also called a stockbroker). Advisers build portfolios and execute trades on your behalf in exchange for a flat fee or a percentage of the value of your portfolio every year. If you want to keep more of your money, the easiest and cheapest way to buy stocks and bonds is through an online brokerage or trading platform. We have listed the most popular online investment services below to help you grow and manage your financial future.
Wealthsimple provides simplified wealth management to people with little-to-no investing experience. This full-fledged financial service supports thousands of publicly-traded common stocks, bonds, and exchange-traded funds (ETFs) listed on major Canadian and U.S. exchanges. Fractional Shares is a new feature that lets you own slices of companies for as little as $1. If you're curious about crypto, Wealthsimple has that too.
Make trades, research securities, move your money, and see your portfolio's performance, all in one place with Questrade. You can start with a pre-built portfolio or buy and sell your own stocks, ETFs, bonds, mutual funds, CFDs, GICs, and more. Long term. Short term. Both—or anything in between. No matter what your investing goals are, Questrade has the accounts to help you get there with low commissions that don't eat into your returns.
Scotia iTrade is a great choice for beginner investors, offering accounts for all kinds of investing goals. You can start building your portfolio in minutes with investment options for equities, ETFs, mutual funds, bonds, IPOs, GICs, and options. All members get access to educational tools and resources. Before you even get started, Scotia iTrade lets you open a practice account to dip your toes into online trading risk-free.
Read this Scotia iTrade vs Questrade review to determine which is right for you.
BMO InvestorLine offers tools for investors at all levels with no surprise fees or additional charges. Simply pay one low flat-rate fee for each online trade you make with stocks, options, ETFs, mutual funds, GICs, and bonds. If you need a little help, BMO InvestorLine will provide personalized support from registered investment advisors. If auto-investing is more your speed, you can get matched with a portfolio based on your goals, and BMO InvestorLine will take care of the day-to-day investment management.
Regardless of where you buy stocks or bonds, it's a good idea to dedicate a portion of your portfolio to long-term investments. Many studies show that investors who hold onto stocks for more than 10 years will be rewarded with higher returns that offset short-term risks.
The Bottom Line
When you're ready to make some money moves into stocks and bonds, you will have to keep your risk tolerance in check. Investing in stocks always carries an inherent level of risk, especially if you're shooting for short-term gains. If you panic when the market is down and sell your shares, it might be a good idea to go easy on the stocks and focus on bonds.
Frequently Asked Questions
The answer depends on a variety of factors, including your experience level, age, and investment goals. Most people will benefit from a long-term investing strategy, using strategic investment allocation to help determine what percentages of investments should be in bonds vs stocks.
If your goal is to see returns of 9% or more, you should allocate 100% of your portfolio to stocks. To target returns of 8% or more, move 80% of your portfolio to stocks and 20% to cash and bonds. For moderate growth of returns of 7% or more, keep 60% of your portfolio in stocks and 40% in bonds. A conservative portfolio that preserves capital rather than earning higher returns will invest no more than 50% in stocks.
These samples are based on strategic investment allocation, estimating outcomes over 15 years or more.
In general, stocks are riskier than bonds, simply because they offer no guaranteed returns to the investor like bonds do. Trends reveal that bonds typically don't lose as much value as stocks do when the market falls. However, the low-risk nature of bonds typically produces lower returns on your investment compared to stocks. Stocks generally combine unpredictability in the short-term with the potential for better returns in the long-term. Risk-averse investors that prefer the cushion of structured payout schedules would be better off investing in bonds.