Stocks and bonds are the two building blocks of most investment portfolios. They work in very different ways, which is exactly why they're useful together.
Stocks: you're an owner
A share of stock is a small piece of ownership in a company. If the company grows its profits, the shares can rise in value and may pay growing dividends. If it struggles, the shares can fall sharply, and shareholders are last in line if the company fails. Over long periods, stocks have historically delivered higher returns than bonds, with much bigger ups and downs along the way.
Bonds: you're a lender
A bond is a loan to a government or company. The issuer pays you interest (the coupon) on a schedule and returns the original amount (the principal) when the bond matures. Bonds generally offer lower long-term returns than stocks but more predictable income and smaller price swings.
Main types of bonds
- US Treasuries: issued by the federal government; considered the safest from default.
- Municipal bonds: issued by states and cities; interest is often exempt from federal tax.
- Corporate bonds: issued by companies; pay more than Treasuries to compensate for the risk of default. Credit ratings from agencies such as S&P and Moody's grade that risk. Lower-rated "high-yield" bonds pay more and carry more risk.
Bonds and interest rates
Bond prices move in the opposite direction to interest rates. If rates rise, existing bonds paying lower rates become less attractive, so their prices fall. Longer-term bonds are more sensitive to rate changes than short-term ones. Read more in how interest rates affect stocks.
Why hold both?
- Smoother ride: high-quality bonds have often held up better than stocks during downturns, cushioning a portfolio.
- Income: bonds provide regular interest, useful in retirement.
- Rebalancing fuel: when stocks fall, selling some bonds to buy stocks keeps your mix on target.
The relationship isn't perfect. In some periods, such as when inflation and interest rates rise quickly, stocks and bonds can fall together.
How much of each?
It depends on your time horizon and how much volatility you can stomach. Younger investors with decades ahead often hold mostly stocks; people near or in retirement usually hold more bonds. See asset allocation by age. The easiest way to own bonds is through a low-cost bond fund or ETF; see what is an ETF.
This article is educational and not investment advice.
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