Stocks vs. Bonds: Compare the Two Types of Investments

Stocks are investments that offer an ownership stake, or equity in a company, which also grants a claim on its assets and earnings. Those two factors determine a stock’s value and, in turn, a company’s value when bought and sold in a centralized stock market or trading system, like the NASDAQ or New York Stock Exchange. Stocks are usually offered when a private company offers its shares to the public for the first time as part of an initial public offering (IPO). Purchase of the stock brings a company the essential capital it needs to grow and expand. If the IPO is successful, it can bring capital to the investor who purchased the stock.

Stocks turn a profit for stockholders in two ways: through dividends, or regular payments made by a company to shareholders, or through capital appreciation, which is when the share price increases, allowing shareholders to sell them at a higher price. Stocks are riskier and more volatile than bonds, as trading systems are known for their volatility. A stock can rise and fall in price according to any external or internal factors, including investor confidence, earnings reports, and analyst downgrades.

A bond is a loan made to a company or organization by an investor in exchange for interest. Any organization can issue bonds, including governments, and they can be traded and issued, like stocks, but “over the counter,” or informally as part of a non-centralized bond market. There are no shares or equity involved in bonds; companies pay back yield, or interest, to bondholders for a predetermined period—usually 30 years—before repurchasing the bond in full.

Bonds are a lower risk investment than stocks because they deliver consistent interest payments but are not risk-free, especially if the company issuing the bonds goes bankrupt during the bond period. In that case, a bondholder might not receive the total amount of the bond’s principal at the end of the loan’s term.

Many different types of stocks are bought and sold in stock markets, most notably:

1. 1. Common stocks. A common stock (also called an ordinary share or voting share) is a basic stock that offers proportional equity in a business and voting rights on company issues. Common stocks are the most typical kind of stock that average investors can purchase. This volatile stock type can fluctuate significantly with the market—with the possibility of dropping to zero or skyrocketing to almost unlimited levels.
2. 2. Penny stocks. Penny stocks, also known as cents stocks, are a security issued by a small company for a meager price—usually five dollars per share. They are generally not traded on the stock market and are typically considered a higher-risk investment with a greater chance of losing money.
3. 3. Preferred stocks. Preferred stock is a type of medium-risk stock that offers investors proportional equity in a specific business without voting rights. Preferred stocks operate more like a hybrid of stocks and bonds, usually with fixed dividend payments and a predetermined redemption value. This unique stock is popular among risk-sensitive investors because it offers a slower, more stable investment without the chance of significant gains.

Here are the main types of bonds on the bond market:

1. 1. Corporate bonds. A corporate bond is essentially a loan from bond investors to a company. They are considered riskier than government or municipal bonds but also offer the chance for higher returns. Investors avoid high-risk bonds by referring to bond ratings from credit rating companies, which judge the chance of default on a debut. Bonds with a low-default risk are considered investment grade, while loans with a higher default risk are known as junk bonds.
2. 2. Government bonds. A government bond is a loan made to a government, which issues repayment of the principal in full to the bondholder with interest. There are several different kinds of government bonds, including treasury bills and treasury notes from the US Treasury. Government bonds typically offer less risk, especially if the country is established and stabilized, but usually provide a lower return. In comparison, bonds from developing countries can offer greater risk but higher return rates.
3. 3. Junk bonds. As their name suggests, junk bonds are risky bonds with lower credit ratings and a higher chance for default. These bonds are typically avoided by risk-averse investors, but embraced by the most aggressive or risk-friendly investors.
4. 4. Municipal bonds. Municipal bonds are similar to government bonds, but the issuer is a local government—a city, town, or state—seeking to fund infrastructure projects like schools or health resources. The US government bond market is considered one of the largest and safest in the world.
5. 5. Zero-coupon bonds. These bonds have fixed interest rates and no periodic interest payments. Instead, they offer long-term returns by accruing interest and paying out when the bond matures.

There are several critical differences between bonds and stocks, including:

• Equity and debt. Stocks provide investors with equity, which is partial ownership of a company that can be quickly converted into cash. They offer the promise of future income with the health and success of the company. Bonds, by comparison, offer no ownership option but do promise the repayment of a loan with interest.
• Fixed income and capital gains. To make a capital gain, or profit from stocks, they must sell at higher stock prices than what the stockholder initially paid for them. Capital gains can then be turned into cash or reinvested, but they are taxed as either long-term or short-term capital gains. Bonds generate funds through their regular interest payments, though they can also be sold on the bond market as capital gains.
• Rising and falling. Stocks and bonds typically have what’s known as inverse performance. When stock prices are high, investors usually want to take advantage of that increase, which generates more demand for stocks and, in turn, a decrease in bond prices. But when stock prices fall, investors turn to the stability of bonds, which causes stock prices to drop.

Bonds and stocks are both financial securities with respective risks and rewards. Stocks are usually a riskier investment than bonds, because of the numerous factors that can cause their prices to fluctuate, but they can generate higher return rates. While bonds are considered less risky, they can offer lower returns than stocks. However, bonds generate consistent interest payments and solid returns upon maturation.

Since both securities have advantages and disadvantages, expert investors recommend compiling a diversified portfolio that mixes stocks, bonds, and investments in other areas, like real estate, to mitigate losses from a single security.

Get the MasterClass Annual Membership for exclusive access to video lessons taught by the world’s best, including Paul Krugman, Doris Kearns Goodwin, Ron Finley, Jane Goodall, and more.