Stocks vs. Bonds: What's the Difference and How Much of Each?

Most investment portfolios are built mainly from two ingredients: stocks and bonds. They play very different roles, and understanding the difference between them is key to building an investment mix that fits your goals, timeline and comfort with risk.

What stocks are

A stock is a share of ownership in a company. When you buy a share of stock, you become a part-owner of that business, with a claim on a small portion of its assets and earnings.

As a stockholder, you can benefit in two main ways. If the company grows and becomes more valuable, its stock price may rise, and you could sell your shares for more than you paid. Some companies also pay dividends, which are regular payments that distribute a portion of profits to shareholders.

Stock prices can also fall, sometimes sharply. Prices are influenced by company performance, economic conditions, interest rates, investor sentiment and many other factors. In the short term, stock prices can be highly volatile, and even large, well-established companies can see significant declines. Over long periods, however, stocks have historically offered higher average returns than bonds or cash, which is why many long-term investors hold a significant portion of their portfolios in stocks.

What bonds are

A bond is essentially a loan you make to a government, government agency or company. When you buy a bond, the issuer generally agrees to pay you interest, often called the coupon, at regular intervals and to return your original investment, called the principal or face value, on a set date, known as maturity.

Common types of bonds include U.S. Treasury bonds, issued by the federal government, municipal bonds, issued by state and local governments, and corporate bonds, issued by companies. Treasury bonds are backed by the U.S. government and considered among the safest investments. Municipal bonds may offer interest that’s exempt from federal income tax. Corporate bonds generally pay higher interest than government bonds to compensate for greater risk.

Bonds are generally steadier than stocks, providing more predictable income and smaller price swings, but they usually offer lower long-term returns.

Bond risks

While bonds are generally less risky than stocks, they still carry risks.

Interest rate risk is one of the most important. When interest rates rise, the prices of existing bonds usually fall, because new bonds pay higher interest, making older, lower-paying bonds less attractive. Bonds with longer maturities are generally more sensitive to interest rate changes. Conversely, when rates fall, existing bond prices usually rise.

Credit risk, also called default risk, is the possibility that the issuer may not be able to make interest payments or repay principal. Credit rating agencies assess issuers’ creditworthiness. High-yield bonds, sometimes called junk bonds, pay higher interest but carry greater credit risk.

Inflation risk is the possibility that inflation erodes the purchasing power of bonds’ fixed payments. Treasury Inflation-Protected Securities, or TIPS, are designed to help protect against inflation.

Why combine stocks and bonds

Stocks offer growth potential, while bonds can provide income and help cushion portfolio swings. Because stocks and bonds don’t always move in the same direction, combining them can create a smoother ride than holding stocks alone.

During many stock market declines, high-quality bonds have held their value or even risen, helping offset stock losses. That relationship doesn’t hold in every period, however. There have been times when both stocks and bonds declined together, such as when interest rates rose sharply.

A mix of both can help you capture much of the growth potential of stocks while reducing volatility, making it easier to stay invested during difficult markets.

How much of each?

Your mix of stocks and bonds, called your asset allocation, is one of the most important investment decisions you’ll make. It depends on when you need the money, your goals and how you’d feel during market drops.

Investors with longer timelines, such as young people saving for retirement decades away, often hold more stocks, since they have time to recover from downturns and benefit from long-term growth. Investors closer to needing the money, such as those nearing retirement, often hold more bonds to reduce the risk of a major decline right when they need to withdraw funds.

Your personal comfort with risk matters too. If large declines would cause you to panic and sell, a more conservative mix you can stick with may serve you better than an aggressive one you abandon.

Some people use rules of thumb to guide their allocation, though these are only starting points rather than rules.

Simple ways to invest in both

Target-date funds handle the stock and bond mix automatically, starting with more stocks and gradually shifting toward more bonds as the target date approaches. Balanced funds maintain a set mix of stocks and bonds. You can also build your own mix using low-cost stock and bond index funds.

Over time, your mix will drift as stocks and bonds perform differently. Periodically rebalancing back to your target allocation helps keep your risk level consistent.

This article is for education only and isn’t investment advice.