When it comes to choosing investments, you have numerous options. Most investors start with stocks and bonds, the two most common types of security you’ll encounter.
Stocks and bonds often form the building blocks of your portfolio and investment strategy. That’s because stocks and bonds tend to perform differently under different market conditions, and investors can use these differences to help them meet their investment goals.
Here’s an overview of what you need to know about stocks and bonds, where and how to invest in them, and the part they can play in your portfolio.
What is a Stock?
When you purchase a stock, you buy a small piece of ownership, called a share, in a company. Stocks are bought and sold on stock exchanges, and generally speaking stock prices rise and fall based on investor demand. Most of the time, the more people want to purchase a particular stock, the higher the price is likely to be. When fewer people want that stock, prices may drop.
Investor demand—and stock prices—fluctuate for a number of reasons. Good news, like strong sales numbers, the discovery of a life-saving medicine or the unveiling of a popular new product could cause a stock’s price to rise. Likewise, bad news, like product safety issues, poor revenue numbers or earnings estimates that fail to meet investor expectations could cause stock prices to fall.
Investors can potentially make money on stocks by selling their shares at a higher price than they bought them. Additionally, owning stock may entitle you to a share of the company’s profits through dividends. Companies typically face a choice of spending their earnings to research and develop new products or distributing them to shareholders in the form of dividends. Many established companies with predictable revenues and expenses choose to divide a portion of their earnings among investors, paying them a cash dividend at regular intervals during the year.
Dividends can also make stocks more attractive to investors. Consistent dividend payments are a sign of consistent profits. Since share prices generally rise when stocks become more attractive, dividends can amplify returns in two ways—by paying investors in cash, and by increasing stock prices and returns over time.
Over the long term, stocks may offer higher returns than bonds. Since 1926, stocks from large companies have returned an average of 10% per year. For 2019 and going forward, however, the projected compound return for large U.S stocks is forecast to be about 5%. (In contrast, long-term government bonds have returned about half as much as stocks since 1926.)
However, higher returns can come with a tradeoff in the form of higher risk. While stock prices can rise quickly, they can also fall quickly. And bad news from a company providing strong returns may come as a bigger disappointment to investors than bad news from a company investors expect to struggle. After prices fall, it can also take some time for them to recover, which is one of the reasons that stocks are often held as long-term investments.
Not all successful investment strategies involve holding stocks for long periods of time, however. More sophisticated investors, such as hedge funds, might use strategies designed to generate returns over the short term, such as shorting a stock. Investors using this strategy start by borrowing stocks and then selling them quickly in the hope they can buy them back later at a lower price. If they can, they return the stocks to their original owner and keep the difference in price as profit.
Other sophisticated strategies include using stock options, which are contracts that allow investors to buy or sell a given stock at a set price and time. Options allow investors to bet markets will rise and offer some downside protection.
For example, if you buy an option for $20 a share and prices go up to $30, you can use your option to buy shares at the lower price before selling at the higher price. However, if you buy the same option for $20 per share and stock prices fall, you’re under no obligation to use the option to buy.
What is a Bond?
Bonds are interest-bearing securities, issued by companies or governments, that investors can purchase for a set amount of time, known as a bond term. Bonds are a form of debt, similar to a loan. In exchange for this loan, the company or government promises to pay you interest in addition to repaying the original amount of the loan when the term is up. Generally speaking, interest is paid in the form of a regular payment called a “coupon.”
Bonds have three basic components: the price at which you buy them, the interest rate that’s used to calculate your coupon, and the bond’s yield, which is the return an investor receives between the time they purchase the bond and the end of the loan term. The interest rate stays the same throughout the life of the bond, but the bond’s price will change based on the movement of interest rates in the economy.
Those price changes happen because bonds become more or less attractive to other investors based based on a combination of current interest rates and the return another investor could get buying a new bond. When interest rates go down, older bonds that pay higher coupons become more attractive, and their price goes up.
The opposite happens when interest rates go up: the price of older bonds that pay lower coupons goes down. It’s important to remember that in either case, the amount of interest you get paid for holding the bond remains the same.
Generally speaking, bonds are less risky than stocks. Unless the bond issuer stops making coupon payments—known as a default—you’ll receive a fixed return over the life of the bond, in addition to having your principal repaid. That’s one reason bonds are also called fixed-income investments.
The lower risk associated with bonds often translates into lower long-term returns. Government bonds, which are backed by the United States Treasury, have returned between 5% and 6% since 1926. Bonds issued by private companies, also known as corporate bonds, range in quality based on the likelihood that their issuer will be able to make timely payments. In most cases, even the highest-quality corporate bonds pay more interest than government bonds, even though large, established blue-chip companies are unlikely to default on their payments.
On the other end of the spectrum, companies with a shakier track record and a higher risk of default tend to issue bonds with much higher interest rates. While these so-called junk bonds, or high-yield bonds, offer investors a better return, the chances that investors actually receive all their payments are substantially lower.
How can I build a portfolio of stocks and bonds?
Investors can buy a single stock or a single bond to assemble a portfolio piecemeal. However, many investors choose investment vehicles that hold a basket of diverse investments to help them build a more varied portfolio. Investment products such as mutual funds, exchange traded funds (ETFs) and index funds offer investors opportunities to buy a range of stocks, bonds or a mix of both.
The strategy of owning a variety of stocks and bonds individually or through a fund is known as diversification, which helps investors spread the risk of poor performance among multiple stocks or bonds. That way, if a particular business or industry runs into trouble, other more successful businesses or industries can help balance out your returns.
What is a mutual fund?
A mutual fund consists of a basket of investments chosen by fund managers. When you buy a share in a mutual fund, you buy a share of the portfolio. This share represents buying a fraction of a share of each of the stocks and/or bonds the fund holds. Mutual fund prices are determined only at the end of the trading day.
The cost of mutual fund shares depends on the total price of all the assets in the fund’s portfolio. At the end of each day, mutual funds calculate their per-share price, also known as their net asset value, by dividing the total value of the portfolio by the number of outstanding shares held by investors. That calculation provides the price at which shareholders can buy or sell mutual fund shares.
What are exchange-traded funds (ETFs)?
ETFs are similar to mutual funds. Both hold a basket of investments, and owning a share equates to owning a fraction of a share of each of the stocks and/or bonds the fund holds. However, where mutual fund share prices are calculated once a day (at the close of trading), shares of ETFs trade on exchanges all day long, just like individual stocks. As a result, the price of a share in an ETF can fluctuate throughout the day based on stock market demand.
What are index funds?
The investment professionals who build mutual funds and ETFs usually build them with an investment strategy in mind. Often, that means investing in a variety of stocks or bonds with similar traits—for example, large companies, small companies, or companies from a certain industry or a particular part of the world.
Index funds are a type of mutual fund or ETF that matches the companies making up a major stock or bond index, such as the S&P 500, the Dow Jones Industrial Average, or the Bloomberg Barclays Aggregate Bond Index. These funds aren’t actively managed by investment professionals, and as a consequence, buying shares of these funds tend to have lower costs than actively managed mutual funds or ETFs.
How to invest in stocks and bonds
If you want to buy stocks, bonds, mutual funds, and ETFs you generally need to open a brokerage account or another specialized account such as a 401(k) or an IRA. There is one exception: You can purchase government bonds online directly from the U.S. Treasury.
Your goals will help you determine what account, or mix of accounts, you choose. For example brokerage accounts can be good for short-term investment goals, since they provide relatively easy access to your money. Retirement accounts, which don’t allow easy withdrawals, are good for long-term retirement goals. Similarly, 529 plans, which offer a way to save for education expenses, are good long-term planning tools to help you pay for a child’s schooling.
Stash has boiled down its investing philosophy into something it calls the Stash Way, which includes investing for the long term, investing regularly, and diversification. You can find out more about the Stash Way here.