Buzz
Investing is often simpler than people assume, though the technical language can be a challenge. Stocks and bonds are two prevalent terms often encountered in investment discussions. Many aren't clear on the differences, so let's break it down.
Stocks Represent Ownership, Bonds Represent Debt
For many of us, achieving the dream of retirement involves investing our money to allow it to grow over time. While there are various investment options, stocks and bonds represent two broad categories you should consider including in your portfolio.
Simply put, a stock is a share of ownership in a company, also known as equity. When a company goes public, such as Microsoft, Google, or General Motors, they sell ownership stakes to the public. You purchase a share, the company receives your money to expand, and your investment represents a portion of the company's ownership. If the company prospers, like Google has over the years, the value of your shares increases. If the company struggles, like Volkswagen has recently, your shares lose value (or you might even lose them entirely).
Naturally, if a company is thriving, its shares will be priced higher. For example, a single Google share currently costs over $800, whereas a share of Volkswagen is under $150. These numbers fluctuate over time, depending on the company’s performance.
Now, let’s look at bonds. When you purchase a bond, you're essentially lending money to a company (or government). Rather than owning part of the company, you give them money, and in return, they agree to pay you interest. This interest is called a “coupon,” paid at a set rate and schedule. Bonds also have a maturity date: the date by which the issuer must repay the borrowed amount. You also have the option to sell your bond before the maturity date. Depending on current interest rates at the time of sale, you might receive more or less than your original investment.
Due to the predictable nature of bonds, they’re categorized as fixed-income securities. Investopedia explains:
For instance, let’s say you purchase a bond with a face value of $1,000, an 8% coupon, and a 10-year maturity. This means you’ll receive $80 ($1,000*8%) in interest each year for the next 10 years. However, since most bonds pay interest semi-annually, you’ll receive two payments of $40 annually for 10 years. When the bond matures after 10 years, you’ll get back your $1,000.
While the interest earned may not be substantial, with a bond, you generally know what to expect. In simple terms, buying a stock means buying equity, while buying a bond means buying debt.
Stocks are generally seen as riskier investments compared to bonds.
When you purchase a stock, you could potentially see significant returns if the company performs well and your shares increase in value. For instance, if you bought a Google share back in 2004 for $50, by 2007, that share could be worth about $300. Selling it would have netted you a $250 profit. If you had held onto the share until 2017, its value would have risen to about $850, yielding an $800 profit from a single share. Not too shabby! Most investors don’t just buy one share, though. If you had purchased 50 shares of Google in 2004 for $2,500, those shares would now be valued at over $42,000. This shows how stocks are a powerful tool for growing your retirement savings.
Not every company is as successful as Google, though.
A company’s profitability can be impacted by a wide variety of factors, from product recalls to new technological advancements, and even the way consumers choose to spend their hard-earned cash. This is why stocks are typically considered riskier, particularly in the short term. However, the potential reward is higher. For instance, as per investing site Zacks, stocks yielded an annual return of 9.18% from 1959 to 2008, while bonds returned 6.48% annually over the same period.
Of course, this is a generalization, and a stock’s performance will vary based on the company. This is where the S&P 500 comes in. It’s a financial index composed of 500 of the most economically influential companies in the United States. Though their value fluctuates daily, over time, these companies have shown solid performance, making them a safer long-term investment due to their relatively stable value. It’s also important to note that putting all of your money into a single company is probably not a good idea. Many experts advocate for mutual funds, which invest in a range of different stocks.
With bonds, you generally know what to expect. They’re considered safer investments than stocks but don’t provide high returns. If your entire retirement savings are invested in bonds, you probably won’t see substantial growth over time.
As retirement approaches, it’s wise to shift your investment strategy by reducing stock investments and increasing your bond holdings. You don’t have as much time to take risks.
How Much to Allocate in Each Investment Type
While stocks and bonds are essential investment types, there are plenty of other options to consider. But these two should form the foundation of your investment portfolio. The big question is, how much should you invest in each? The answer depends on factors like your age, financial goals, and your ability to handle risk. Here’s a common rule of thumb to help guide you:
110 minus your age = the percentage of your portfolio allocated to stocks
For example, if you’re 30 years old, you would put 80% of your portfolio into stocks (110 - 30 = 80) and the remaining 20% into safer bonds. If you lean more towards a conservative strategy, you might prefer to allocate 30% to bonds instead. While some people may consider this approach too cautious, it offers a solid starting point.
As you age, it’s important to adjust your portfolio. If you follow the 110 rule, when you turn 40, your bond allocation should rise to 30% instead of 20%. As you approach retirement, your investment strategy should shift toward stability, as there’s less time to recover from risks. The closer you are to retirement, the more essential it is to protect your investments, because if your stocks drop, you won’t have as many years left for recovery.
There are several tools available to assist you in determining how much to invest in each category. For instance, Bankrate’s asset allocation calculator is a great option, or you can opt for a comprehensive investment tracker like Personal Capital.
Of course, investing is much more nuanced. Stocks and bonds come in various types, and there are several ways that stocks reward their investors. However, these two investment types are the foundation, and if you’re just starting out, it’s crucial to understand how they function to help you grow your savings over time.
