The Difference Between Stocks and Bonds

Understanding Asset Classes

Stocks and bonds represent two different asset classes available to buy, sell or trade on the stock market. Asset classes are groups of securities that behave similarly and share similar characteristics. Other classes include cash, real estate and commodities.

Investors usually seek to hold a variety of asset classes within their investment portfolios. This helps you diversify, which in turn helps protect against risk. It's the investment version of that old adage, "Don't put all your eggs in one basket."

The Difference Between Stocks and Bonds

Behavior, risk and potential reward are the main differences between stocks and bonds.

When you purchase a stock, you're purchasing a limited ownership share in a company. Historically, stocks provide the most return on investment. But because stock prices and company valuations can be volatile, stocks carry a distinct risk.

When you purchase a bond, on the other hand, you're essentially lending money to another entity. If you buy government bonds, for example, you become a lender to Uncle Sam. While bonds provide returns to investors, too, they're historically much lower than those provided by stocks.

But because bonds' lower returns are associated with stability, they are potentially a good choice when you need your investments to generate long-term income (which, for most people, is in retirement).

Where Mutual Funds Come Into Play

Mutual funds are like mixed bags of assets from various classes. Multiple investors pool their money to buy in to a set of assets together. Funds are typically managed by an investment expert or brokerage firm. Using mutual funds allows you to access far more securities than you could if you bought everything in the fund one-by-one on your own. Because of their diversity, mutual funds are generally considered a good choice for investors reluctant to take on the risk level of buying stocks in individual companies.

What Does All This Mean for Your Investments?

Even though there's a big difference between stocks and bonds, they both play an important role in a diverse and balanced portfolio. The percentage of stocks and bonds (and other assets) you hold is called your asset allocation. The right allocation for you depends on factors like your age, goals and risk tolerance.

The younger you are, the more stocks you're generally advised to hold in your portfolio. When you're young, you have more time to weather market ups and downs. Meaning if you take a hit from a big risk, you'll have time to come back from it. While stocks are more volatile, experts like Warren Buffett say that you can expect about a six to seven percent return if you invest for 10 years or more.

When you're older, though, you have less time to let your investments ride out market volatilities that can cause losses in your portfolio. So you need greater stability, which means investing more in bonds than in stocks.

The language of investing can be complex, but it's a challenge worth taking on. A deeper understanding of investments can only help your finances and give you greater confidence moving forward.