When diversifying your portfolio, you’ll read article upon article about stocks and bonds. They’re referenced together so often that they’ve become synonymous to those who are unclear of the differences. However, understanding how they differ can help you to choose which assets best fit your needs. In this article, we’ll share details on each to give you insight into how these two instruments contribute to diversification.
The Characteristics of a Stock
- Stocks represent a share of a company, allowing a stockholder to own a small portion of the business and potentially receive dividends on it, if that company pays a quarterly dividend.
- With this type of asset, you own a piece of the business, even if it’s small. The percentage of the company’s assets that you own is determined by the number of shares a company—for example, if 10,000 shares are available and you were to purchase 500 shares, you would then own 5% of that company’s shares outstanding.
- Your investment in stocks does not guarantee a return, as a stock’s value depends on supply and demand and that specific company’s performance.
- At its base, a stock represents equity in a company, whereas bonds are representative of debt.
So, let’s take a look at the characteristics of a bond to see how they compare.
The Characteristics of a Bond
- As we mentioned in the previous section, bonds represent debt. In this case, instead of issuing a piece of its company (like stocks), an entity will issue you a unit of debt with an agreement to pay you interest. This is their way of raising funds to pay for necessities or to expand their organization without having the capital upfront.
- You can picture a bond as an I.O.U. from a governmental or corporate entity, with the promise that they will pay interest, which is referred to as the bond’s “coupon rate.” The coupon rate is the percentage of interest that the entity will pay on the bond’s face value. If the bond is worth $1,000, for example, and the coupon rate is 5%, you would receive $50 annually.
- Bonds still function in a market setting, meaning that bonds are bought and sold similarly to stocks in the stock market.
- Overall, in our opinion bonds can potentially pose less risk than stocks, as there is an agreement in place between you and the entity that requires them to pay you the annual rate. However, it is important to note that the issuer could default on their payments, or the bond’s yields could fall.
Why These Differences Are Important
Stocks and bonds are both means of raising funds for an entity—but the way they raise those funds is what you must pay attention to when diversifying. Overall, when it comes to your portfolio, it’s crucial to acknowledge that stocks have a considerable amount of risk, whereas bonds are usually much safer investments.
This does not mean that one is better than the other; it all depends on your risk tolerance. Depending on several factors, such as your age and financial goals, you and your advisor will determine the number of stocks and bonds that you should invest in.
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