As an investor, there’s a wide range of asset classes that you can invest in to build a portfolio that aligns with your investment goals. Some assets tend to be riskier investments than others, representing different types of ownership and benefits for investors.
Two of the most common assets investors might add to their portfolio: stocks and bonds.
What are stocks and how do they work?
Stocks are a type of asset class that represent a partial ownership in a company. For companies, stocks serve as sort of a bargaining chip with investors. In exchange for a piece of the pie (company ownership and potential profit), companies are able to raise capital from selling shares to cover their costs and expand their business. Stocks are purchased and sold on stock exchanges, which act as the intermediary between investors and companies.
When the company does well, so do shareholders. “If you own a share of stock of Apple as an example, you own a piece of the company and are entitled to its profits through either the stock price appreciating (increasing) or dividends (cash payments returning profits to shareholders),” says Brendan Halleron, certified financial planner, AIF®, BFA™, and partner and financial planner at Affiance Financial in Minneapolis, MN.
But on the flipside, when a company’s performance tanks, shareholders may feel the burn and see a decrease in the value of their shares.
“Some risks of investing in a stock include headline risk, a news story that negatively affects a stock’s price; insolvency risk, also known as bankruptcy risk; legislative risk, passing laws that are unfavorable to the company’s industry; commodity risk, increased input costs of the company’s goods; and overall economic risk,” says Halleron. “That might sound like a lot of risk, and it’s true, there are a lot of risks when investing in stocks, but in exchange, stocks generally present a better opportunity for investors to earn a higher rate of return.”
What are bonds and how do they work?
A bond is essentially a loan from you, the investor, to a corporation, government entity, or other organization. In exchange for your capital, you’ll receive interest payments from the borrower until your loan’s term ends (i.e., the bond “matures”), and then they’ll be expected to repay their loan in full. Investors can purchase bonds directly from the issuing government entity or corporation or through a brokerage.
While bonds are often deemed a safer asset and a steady income-earning investment, they are not without their own set of risks.
“The main risks include interest rate risk, owning a bond with a lower interest rate than what you can buy on the market; and credit risk, an organization being unable to pay its debts,” says Halleron. “The reward for investing in bonds is stable cash payments at a stated interest rate over a defined period of time—in other words, more certainty. In exchange for that, you sacrifice the potential opportunity to earn a higher return by investing elsewhere.”
The key differences between stocks and bonds
Each type of asset works a little differently in what it represents, how profit is generated and distributed, and what kinds of rights investors are guaranteed. Before you invest in either asset, consider the following key differences between stocks and bonds:
How to choose the right asset type for your portfolio
Determining which asset class to invest in and the right split between stocks and bonds will come down to a few different factors, including your:
- Risk tolerance: Your risk tolerance is the amount of loss you’re willing to stomach if an investment goes south. Some investors are prepared to risk it all if it means a higher reward. Others are okay with smaller, safer profits. Your risk tolerance can also change over time depending on your financial situation and timeline. If you’re younger and you’re investing for retirement, you might be in a position to invest more money in riskier assets because you have time to make up for any losses you might incur on the way to hitting your goal. If you’re older and don’t have as much time to recover from potential losses, you might go the safer route and invest more money in safer, lower-risk assets.
- Time horizon and investment goals: Your time horizon is the amount of time you expect to hold an investment before you need access to your money. Say you’re investing to buy a house in three years—that would be considered a short-term time horizon, whereas a 20-something who is investing for retirement has a longer-term time horizon. Think carefully about your goal and when you’ll need to cash in on your investments. This can help guide your decision about the ideal percentage of your portfolio that should be invested in bonds vs. stocks. Generally, the shorter your time horizon, the more you want to invest in safer assets. With a longer horizon, you can afford to be a bit more of a risk-taker. Although this isn’t a universal truth, individual investors may still opt to take on more risk even with a shorter time horizon.
Ideally, you’ll want your portfolio to be made up of a few different asset classes. Diversifying your asset mix with both stocks and bonds can help spread out some of the inherent risk that comes with investing.
“A well-diversified portfolio reduces your overall risk by investing in a large variety of non-correlated assets. By doing so, your investment performance will never ‘kill it’ (outperform the stock market), but you will also never ‘be killed’ (lose all your money),” says Halleron.