Stocks vs. Bonds: Know The Difference (2024)

From real estate to precious metals, the world offers a variety of options for investing your money. Stocks and bonds are two of the most common.

Both options can play an important role in your investment portfolio, but how much you invest in each depends on your investment goals, time horizon and risk tolerance. Understanding the fundamentals of stocks and bonds as well as their differences can help you make the best investment decisions for your needs.

What Are Stocks?

Stocks are one of the best-known investment options. Also known as equities, stocks are a type of security that gives you a share of ownership in a specific company. For example, you can buy stocks and become a shareholder of major companies like Apple (AAPL), Tesla (TSLA) or Intel (INTC).

By buying stocks, you can potentially grow your money through capital appreciation, meaning the stock’s price increases. You could also earn dividends if the company distributes a portion of its earnings to stockholders.

There are two main types of stock:

• Common: Common stocks represent ownership of a company. Owning common stock entitles you to receive dividends and vote at shareholder meetings.
• Preferred: With preferred stocks, shareholders don’t have voting rights, but they receive dividend payments before common stock shareholders do. And if a company goes bankrupt and its assets are liquidated, preferred stockholders get priority.

Stocks are sold on stock exchanges, such as the Nasdaq or the New York Stock Exchange. They offer the greatest potential for growth, but they also come with significant risk. Stock prices can drop significantly in a short time, so it’s possible to lose money investing in stocks.

What Are Bonds?

While stocks are equities, bonds are known as debt securities.

With bonds, the company or organization issuing the bond acts as a borrower and raises money from investors to fund projects or expansion efforts. In essence, you are lending money to the issuer. In exchange, the issuer promises to pay you a rate of interest on top of the bond’s principal.

There are several kinds of bonds:

• Corporate: Corporate bonds are issued by private and public companies.
• Municipal: Municipal bonds are issued by states, cities and counties.
• Treasury: Treasury bonds are issued by the U.S. Department of the Treasury on behalf of the federal government. They’re backed by the government, so they are a relatively safe investment option.

By investing in bonds, you can get a predictable and reliable stream of income through interest payments. If you hold onto the bond until its maturity date, you also get back the entire principal, so there’s little risk involved. Investors often use bonds to balance out riskier investment options, such as individual stocks, to protect against market volatility.

Depending on the type of bond, you can buy them through online brokerage accounts, mutual funds, exchange-traded funds (ETFs) or directly through the government or government agency.

Stocks vs. Bonds: Key Differences

Although both stocks and bonds are popular investment options, there are several key differences to be aware of before investing your money.

Returns

Historically, stocks have higher returns than bonds. According to the U.S. Securities and Exchange Commission (SEC), the stock market has provided annual returns of about 10% over the long term. By contrast, the typical returns for bonds are significantly lower. The average annual return on bonds is about 5%.

Risk

Although stocks have greater potential for growth than bonds, they also have much higher levels of risk. With stocks, the prices can rise and fall for a variety of reasons, including factors outside of the company’s control. For example, supply chain issues and even weather conditions can affect a company’s production and cause stock prices to plummet.

Bonds are relatively safer. Because they’re a debt security, they function as an IOU. The company pays you interest, and once the bond matures, you get your principal bank.

Bonds aren’t completely risk-free; there is the possibility of the issuer defaulting on its bonds or inflation reducing the value of the bond. But compared to stocks, there’s less volatility.

Taxes

How the securities are taxed is another major differentiator between stocks and bonds. With stocks, you pay capital gains taxes when you sell a stock at a profit and on any dividends you receive.

Bonds are often handled differently. With bonds, you are taxed on the interest you earn and on any capital gains. However, what taxes you pay is dependent on the type of bond you invest in:

• Corporate: With corporate bonds, the interest you earn is nearly always taxable as income.
• Municipal: Interest that you earn from investing in municipal bonds is usually exempt from federal income taxes. Interest earned from state municipal bonds may also be exempt from state income taxes. But if you purchase bonds from another state, you’ll usually have to pay both state and local taxes.
• Treasury: Interest from treasury bonds is exempt from state and local income taxes. However, it’s taxable at the federal level.

In most cases, bonds aren’t subject to capital gains. If you buy a bond and hold onto it until its maturity date, you won’t have a gain or a loss; you just get the principal back. But if you sell the bond on the secondary market for more than you paid for it, you’ll have to pay capital gains taxes.

Taxes on your investments can become complicated. Finding a good tax preparer or certified public accountant (CPA) can help you prepare your tax returns accurately and plan for the future.

What’s a Better Investment Choice, Stock or Bonds?

Now that you know the difference between stocks and bonds, it’s up to you to decide which investment type is best for you and your financial goals.

Generally, bonds are best for those that are conservative and nearing retirement age. They provide steady, reliable income and have relatively low levels of risk.

If you have more time to reach your goals, investing in the stock market is likely a better option than bonds. By investing in stocks, you have more potential for growth, and you can weather market fluctuations.

If you’re still not sure, you may want to consider a target date fund. These funds are all-in-one solutions and invest in baskets of stocks and bonds that suit your retirement goals and risk tolerance.

When you’re younger, the target date fund primarily invests in stocks. But as you near your targeted retirement age, the fund becomes increasingly conservative and shifts its investments to bonds. They provide portfolio diversification, so they’re an acceptable option for passive, hands-off investors.