What are better, stocks or bonds?
It’s kind of like asking, “What’s better, chocolate or vanilla ice cream?” Both are great for different reasons.
First, why stocks? Well, stocks are ownership. This means if the company sells a lot of stuff, expands into different countries, and makes a lot of money, you get to go along for the ride. Your little piece of ownership goes up with the company.
As an owner in the company, you may get part of the profits. Pop quiz! Do you remember what these were called? They are called dividends. You may get some of the profits through dividends, which are just cash payments. And if the company does well, the price of the stock may increase in value. Just like the price of a house can go up in value, the stock can go up in value, too. This is called growth or appreciation.
If you look back in time over many years, on average, stocks have gone up around 12% per year. This means if you invest $100 in a stock and it goes up 12%, then at the end of the year, you have $112. But these are averages across all stocks. Some went up much more than 12%. For example, Apple stock has gone up 44% each year on average over ten years, starting in 2002. Of course, not all stocks are Apple and not all stocks go up 44% a year, or even 12% a year. In fact, some stocks didn’t go up at all. They went down. And some went out of business. Think about companies such as Circuit City, Blockbuster Video, Best Buy, RadioShack, and others. Not all companies continue to produce things the public wants.
Stocks fluctuate a great deal. They can be up 12% one year and down 20% the next. The technical term for this roller-coaster-ride instability is volatility. Lots of ups and downs. But with patience and over longer periods, stocks are one of the best performing investments you can have.
What about bonds? Well, bonds are quite different.
Remember, while a stock is ownership in the future success of the company, a bond is just a promise from the company that they will pay you back the money they borrowed from you and throw in a little extra money called interest.
Why bonds then? Well, they tend to be more stable. They aren’t up and down drastically like stocks, meaning they are less volatile. The big benefit of a bond is you get stable income. You know you will get a certain amount of interest every six months. With a stock, who knows? Nothing is guaranteed. With a bond, you have an agreement that commits the company to paying you. This is a big draw for bond investors. They like the stability and they like the cash flow. And even better, if the company goes out of business, the bondholders get their money back before the stock owners. How do you like that? As a stock owner, you have to wait until everyone else is paid back before you get anything. As a bond owner, you get your money back first. Again, that’s stability and security. That’s what a bond provides.
So, what is better? Both stocks and bonds have vastly different characteristics with different benefits. Stocks are for growth. Bonds are for income. They both have a place in everyone’s portfolio.
The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.