Bonds vs. Stocks: A Beginner’s Guide - NerdWallet (2024)

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The biggest difference between stocks and bonds is that with stocks, you own a small portion of a company, whereas with bonds, you loan a company or government money. Another difference is how they make money: stocks must grow in resale value, while bonds pay fixed interest over time. These two investment types can play essential roles in a portfolio but work in distinct ways.

Stocks

Stocks represent partial ownership, or equity, in a company. When you buy stock, you’re purchasing a tiny slice of the company — one or more "shares." And the more shares you buy, the more of the company you own. Let’s say a company has a stock price of $50 per share, and you invest $2,500 (50 shares for $50 each).

Now imagine, over several years, the company consistently performs well. Because you’re a partial owner, the company’s success is also your success, and the value of your shares will grow just like the value of the company. If its stock price rises to $75 (a 50% increase), the value of your investment would rise 50% to $3,750. You could then sell those shares to another investor for a $1,250 profit.

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Of course, the opposite is also true. If that company performs poorly, the value of your shares could fall below what you bought them for. In this instance, if you sold them, you’d lose money.

Stocks are also known as corporate stock, common stock, corporate shares, equity shares and equity securities. Companies may issue shares to the public for several reasons, but the most common is to raise cash that can be used to fuel future growth.

» Check out our roundup of the best online brokerages for stock trading

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Bonds vs. Stocks: A Beginner’s Guide - NerdWallet (4)

Bonds

Bonds are loans from you to a company or government. There’s no equity involved, nor any shares to buy. Put simply, a company or government is in debt to you when you buy a bond, and it will pay you interest on the loan for a set period, after which it will pay back the total amount you purchased the bond for.

But bonds aren’t entirely risk-free. If the company goes bankrupt during the bond period, you’ll stop receiving interest payments and may not get back your principal.

Suppose you buy a bond for $2,500, which pays 2% annual interest for 10 years. That means you’d receive $50 in interest payments annually, typically distributed evenly throughout the year. After 10 years, you would have earned $500 in interest, and you’d get back your initial investment of $2,500, too. Keeping a bond for the full duration is known as “holding until maturity.”

With bonds, you usually know what you’re signing up for, and the regular interest payments can be used as a source of predictable fixed income over long periods.

The duration of bonds depends on the type you buy, but they commonly range from a few days to 30 years. Likewise, the interest rate — known as yield — will vary depending on the type and duration of the bond.

» Learn more: What is a bond?

Comparing stocks and bonds

While both instruments seek to grow your money, the way they do it and the returns they offer are very different.

» Want to get started? Learn and

Equity vs. debt

When you hear someone talk about equity and debt markets, they’re typically referring to stocks and bonds. Corporations often issue equity to raise cash to expand operations, and in return, investors can benefit from the future growth and success of the company.

Buying bonds involves issuing a debt that’s repaid with interest. You won’t have any ownership stake in the company, but you’ll agree that the company or government must pay fixed interest over time and the principal amount at the end of that period.

Capital gains vs. fixed income

Stocks and bonds generate cash in different ways, too.

To make money from stocks, you’ll need to sell the company’s shares at a higher price than you paid to generate a profit or capital gain. Capital gains can be used as income or reinvested but will be taxed as long-term or short-term capital gains accordingly.

Bonds generate cash through regular interest payments such as:

  • Treasury bonds and Treasury notes: Every six months until maturity.

  • Treasury bills: Only upon maturity.

  • Corporate bonds: Semiannually, quarterly, monthly or at maturity.

Bonds can also be sold on the market for a capital gain, though for many conservative investors, the predictable fixed income is what’s most attractive about these instruments. Similarly, some stocks offer fixed income that more resembles debt than equity, but this usually isn’t the source of stocks’ value.

» Learn more about the different types of bonds and how to buy them

Inverse performance

Another important difference between stocks and bonds is that they tend to have an inverse relationship in terms of price — when stock prices rise, bond prices fall, and vice versa.

Historically, when stock prices rise and more people are buying to capitalize on that growth, bond prices typically fall on lower demand. Conversely, when stock prices fall, investors want to turn to traditionally lower-risk, lower-return investments such as bonds, and their demand and price tend to increase.

Bond performance is also closely tied to interest rates. For example, if you bought a bond with a 4% yield, it could become more valuable if interest rates drop because newly issued bonds would have a lower yield than yours. On the other hand, higher interest rates could mean newly issued bonds have a higher yield than yours, lowering demand for your bond (and its value).

To stimulate spending, the Federal Reserve typically cuts interest rates during economic downturns — periods that are usually worse for many stocks. But, lower interest rates can increase the value of existing bonds, reinforcing the inverse price dynamic.

But there are exceptions to this: 2022, for example, wasn't your typical year. The Fed raised interest rates to tamp down rising inflation, and both stocks and bonds did poorly.

Taxes

Since stocks and bonds generate cash differently, they are taxed differently. Bond payments are usually subject to income tax, while profits from selling stocks are subject to capital gains tax. Capital gains taxes may be lower than income taxes for investors in some income brackets.

However, bonds may come with tax benefits you might not get with stocks.

Municipal bond payments are exempt from federal income tax. Most states also exempt their own municipal bonds (but not out-of-state municipal bonds) from state income taxes.

Treasury bond payments are generally exempt from state income tax, although they are fully subject to federal income tax.

» Dive deeper. See how stocks and bonds might fit into your

The risks and rewards of each

Stock risks

The biggest risk of stock investments is the share value decreasing after you’ve purchased them. Stock prices fluctuate for several reasons (you can learn more about them in our stock starter guide). If a company’s performance doesn’t meet investor expectations, its stock price could fall.

Given the numerous reasons a company’s business can decline, stocks are typically riskier than bonds.

However, with that higher risk can come higher returns. The market's average annual return is about 10%, not accounting for inflation. In contrast, the U.S. bond market, measured by the Bloomberg Barclays U.S. Aggregate Bond Index, has an all-time return of around 6%, also not accounting for inflation.

Bond risks

U.S. Treasury bonds are generally more stable than stocks in the short term, but this lower risk typically translates to lower returns, as noted above. Treasury securities, such as government bonds, notes and bills, are virtually risk-free, as the U.S. government backs these instruments.

Corporate bonds, on the other hand, have widely varying levels of risk and returns. Bonds from a company with a high likelihood of going bankrupt will be considered much riskier than those from a company with a low chance of going bankrupt. Credit rating agencies such as Moody’s and Standard & Poor’s assign a credit rating that reflects the company’s ability to repay debt. Corporate bonds are classified as either investment-grade bonds or high-yield bonds.

Corporate bonds can be grouped into two categories: investment-grade bonds and high-yield bonds.

  • Investment grade. Higher credit rating, lower risk, lower returns.

  • High-yield (also called junk bonds). Lower credit rating, higher risk, higher returns.

These varying risks and returns help investors choose how much of each to invest in — otherwise known as building an investment portfolio. According to Brett Koeppel, a certified financial planner in Buffalo, New York, stocks and bonds have distinct roles that may produce the best results when they complement each other.

"As a general rule of thumb, I believe that investors seeking a higher return should do so by investing in more equities, as opposed to purchasing riskier fixed-income investments," Koeppel says. "The primary role of fixed income in a portfolio is to diversify from stocks and preserve capital, not to achieve the highest returns possible."

» Dive deeper. Learn more about fixed-income investments like bonds.

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Bonds vs. Stocks: A Beginner’s Guide - NerdWallet (5)

Should you buy stocks or bonds?

When it comes to stocks vs. bonds, one isn't better than the other. They serve different roles, and many investors could benefit from a mix of both in their portfolios. Diversification is an important technique for managing investment risks — and a portfolio containing a mix of stocks and bonds is more diversified and potentially safer than an all-stock portfolio.

There are many adages to help you determine how to allocate stocks and bonds in your portfolio. One says that the percentage of stocks in your portfolio should equal 100 minus your age. So, if you’re 30, such a portfolio would contain 70% stocks and 30% bonds (or other safe investments). If you’re 60, it might be 40% stocks and 60% bonds.

The core idea here makes sense: As you approach retirement age, you can protect your nest egg from wild market swings by allocating more funds to bonds and less to stocks.

However, detractors of this theory may argue this is too conservative of an approach given our longer lifespans today and the prevalence of low-cost index funds, which offer a cheap, easy form of diversification and typically less risk than individual stocks. Some argue that 110 or even 120 minus your age is a better approach today.

For most investors, stock/bond allocation comes down to risk tolerance. How much volatility are you comfortable with in the short term in exchange for stronger long-term gains?

Consider this: A portfolio comprising 100% stocks is almost twice as likely to end the year with a loss than a portfolio of 100% bonds. Considering your timeline, are you willing to weather those downturns in exchange for a higher likely return over the long term?

The upside down: When debt and equity roles reverse

Certain stocks offer the fixed-income benefits of bonds, and some bonds resemble the higher-risk, higher-return nature of stocks.

Dividends and preferred stock

Large, stable companies that regularly generate high profits often issue dividend stocks. Instead of investing these profits in growth, they often distribute them among shareholders — this distribution is a dividend. Because these companies typically aren’t targeting aggressive growth, their stock price may not rise as high or as quickly as smaller companies. However, consistent dividend payouts can benefit investors looking to diversify their fixed-income assets.

Preferred stock resembles bonds even more and is considered a fixed-income investment that's generally riskier than bonds but less risky than common stock. Preferred stocks pay out dividends that are often higher than both the dividends from common stock and the interest payments from bonds.

Selling bonds

Bonds can also be sold on the market for capital gains if their value increases higher than what you paid, which could happen due to changes in interest rates, an improved rating from the credit agencies or a combination of these.

However, seeking high returns from risky bonds can defeat the purpose of investing in bonds in the first place — to diversify away from equities, preserve capital and provide a cushion for swift market drops.

Neither the author nor editor held positions in the aforementioned investments at the time of publication.

Bonds vs. Stocks: A Beginner’s Guide - NerdWallet (2024)

FAQs

Bonds vs. Stocks: A Beginner’s Guide - NerdWallet? ›

Stocks and bonds

How are bonds different from stocks a beginners guide? ›

The biggest difference between stocks and bonds is that with stocks, you own a small portion of a company, whereas with bonds, you loan a company or government money. Another difference is how they make money: stocks must grow in resale value, while bonds pay fixed interest over time.

How much money do I need to invest to make $1000 a month? ›

The truth is that most investors won't have the money to generate $1,000 per month in dividends; not at first, anyway. Even if you find a market-beating series of investments that average 3% annual yield, you would still need $400,000 in up-front capital to hit your targets.

Should I invest more in stocks or bonds? ›

As you can see, each type of investment has its own potential rewards and risks. Stocks offer an opportunity for higher long-term returns compared with bonds but come with greater risk. Bonds are generally more stable than stocks but have provided lower long-term returns.

Is it easier to value a stock or bond? ›

Valuation of a stock is more difficult compared to bond valuation because stocks lack a maturity value. The prediction of the future amount of money that is related to stock is hard since it bases upon the profitability of a company and the amount of money that can be distributed to the stockholders.

Why buy bonds instead of stocks? ›

Stocks offer ownership and dividends, volatile short-term but driven by long-term earnings growth. Bonds provide stable income, crucial for wealth protection, especially as financial goals approach, balancing diversified portfolios.

Why would someone buy a bond instead of a stock? ›

Bonds are more beneficial for investors who want less exposure to risk but still want to receive a return. Fixed-income investments are much less volatile than stocks, and also much less risky.

How to make $2,500 a month in passive income? ›

  1. 14 Proven Ways to Make $2,000-$3,000 Per Month in Passive Income. ...
  2. Build a High-Earning Blog. ...
  3. Self-Publish Books on Amazon Kindle. ...
  4. Invest in a High Cash Flow Duplex House. ...
  5. Fund Real Estate Projects with Crowdfunding. ...
  6. Invest in Triple Net Lease Properties. ...
  7. Launch Multiple Affiliate Websites.
Jan 2, 2024

How can I make $1000 a month passively? ›

Investing in high-yielding dividend stocks can be a reliable means of earning a stable passive income. One has to invest around $180,000 in monthly-paying dividend stocks, which offer dividend yields of over 6.7%, to earn a monthly income of $1,000.

How much will I have if I invest $500 a month for 10 years? ›

What happens when you invest $500 a month
Rate of return10 years30 years
4%$72,000$336,500
6%$79,000$474,300
8%$86,900$679,700
10%$95,600$987,000
Nov 15, 2023

What is the downside to bonds? ›

Credit risk is a disadvantage of corporate bonds. If the issuer goes out of business, the investor may never get the promised interest payments or even get their principal back.

Will bonds outperform stocks in 2024? ›

Stocks and bonds deliver positive returns and cash underperforms both as the Fed pivots to rate cuts. Stocks and bonds may both be poised for success in 2024. Easing inflation and a pivoting Fed should reduce headwinds that have faced both asset classes in recent years.

Is a 5 year CD worth it? ›

A five-year CD usually offers the highest rate of return of any CD, though now, shorter terms like one-year CDs offer higher rates. Experts say this is a sign that savings rates have peaked and are unlikely to climb much higher, especially since the Fed paused rates for the third consecutive time in December.

What are the five drawbacks of investing in bonds? ›

Risk #6: Low liquidity in some bonds can cause price volatility.
  • Interest Rate Risk and Bond Prices. The first thing a bond buyer should understand is the inverse relationship between interest rates and bond prices. ...
  • Reinvestment Risk and Callable Bonds. ...
  • Inflation Risk. ...
  • Credit/Default Risk. ...
  • Rating Downgrades. ...
  • Liquidity Risk.

Do bonds ever outperform stocks? ›

So, although the entire 227-year span of McQuarrie's analysis from 1793 to 2019 was weakly supportive of Siegel's conclusions, there were subperiods where bonds actually outperformed stocks, leading McQuarrie to conclude that there was no consistent relationship between asset outperformance and length of holding period ...

Should you buy bonds when interest rates are high? ›

Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.

What is a bond How is it different from a stock? ›

A stock is an investment in a company. Your investment (purchased in shares) can grow or decline based on the company's success. A bond is an investment in a company's or government's debt. After you purchase a bond, the entity develops a plan to repay the principal of your investment with interest.

How do bonds work for beginners? ›

Bonds are an investment product where you agree to lend your money to a government or company at an agreed interest rate for a certain amount of time. In return, the government or company agrees to pay you interest for a certain amount of time in addition to the original face value of the bond.

How do bonds work for dummies? ›

The people who purchase a bond receive interest payments during the bond's term (or for as long as they hold the bond) at the bond's stated interest rate. When the bond matures (the term of the bond expires), the company pays back the bondholder the bond's face value.

How is a bond different from a stock quizlet? ›

Bonds give payments before equity owners are paid. Bonds mature while stock have no maturity date. Bond payments are fixed by the coupon payment and do not promise growth in payments.

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