Investing in stocks and bonds
Stocks and bonds are often referenced together in investment planning discussions, but these two types of securities are quite different.
The differences between stocks and bonds as investment options are why many strategists believe they make a good match. By blending stocks and bonds together using an asset allocation strategy, investors may be able to take advantage of markets that move up while also limiting losses when markets move down. Here are answers to some common questions about stocks and bonds.
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When you buy a share of stock, you are essentially buying an ownership stake in a company. Over time, share prices can increase as a company’s performance and profits increase.
- For example, if a certain company’s stock price is $100 per share, and you buy 10 shares, you’ve invested $1,000 in that company. In five years, if that stock price were to increase to $500 per share, your initial 10 shares have grown to be worth $5,000. Your profit is $4,000 or 400% of your initial investment.1
- While stocks have the potential to generate profit over time, you also run the risk of the share value declining if the company’s performance declines. For instance, if that same company’s stock price falls to only $40 per share over the course of those five years, you would have lost $600, or 60% of your initial investment.1
Many companies also share a portion of their revenues with shareholders by paying the shareholder a dividend. Dividends are not guaranteed and can vary over time but when received this adds to your return.
To help reduce risk, it’s generally a good idea to diversify your stock portfolio by investing in more than one company, industry, and kind of stock.
There are many different kinds of stocks, including:
- Growth stocks: Often in new or growing industries with the potential for earnings to increase at a faster rate than the market average
- Value stocks: Value stocks come from companies with good earnings that are selling shares at lower prices relative to their value.
- Income (or High Dividend) stocks: These usually pay steady dividends but historically have not experienced strong share price growth. This category was at one time dominated by energy, financial services and utilities, but more technology companies are now paying and growing dividends.
- Blue chip stocks: These are stocks of large and well-regarded companies with a strong growth history. They also often pay dividends.
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When you buy bonds, you are loaning money to the bond issuer, which is typically a company or government agency. Unlike with stocks, you don’t obtain ownership stake in the company when you invest in bonds. Bonds have a maturity date when the loan is due to be paid in full, and they usually offer fixed or variable interest payments.
A general rule of thumb is bonds that have longer maturities offer the higher the interest rates because investors are taking on a greater risk. Similarly, higher-quality bonds generally offer lower interest rates because the investors’ risk is generally lower. Bonds also have varying levels of liquidity.
Here are some of the most common types of investment bonds available to investors:
- Corporate bonds: These are issued by private corporations. The debt can be paid off by the company and redeemed by a fixed date, paying you back your principal and accrued interest. Or, in the case of callable bonds, the corporation can “call” or redeem the bond which allows them to pay off their bonds before the maturity date. Corporate bonds are typically categorized as either investment grade bonds or high-yield bonds.
- Investment grade bonds: Usually offer lower yields because they have lower interest rates and have higher credit ratings.
- High yield bonds: Typically pay higher interest rates because they have lower credit ratings than investment-grade bonds. High-yield bonds are more likely to default, so they must pay a higher yield than investment-grade bonds to compensate investors.
- Municipal bonds: Municipal bonds are issued by states, counties or municipalities. They’re usually exempt from federal income tax and can also be exempt from state income tax under certain conditions. While these bonds tend to offer the lowest interest rates, their overall returns for investors can be higher due to their tax advantages.
- Government bonds: Government bonds that are backed by the U.S. government, such as U.S. treasury notes, are typically considered a lower risk investment option. While the terms can vary from a few days to several years, the government guarantees the lender to be paid in a timely manner with interest. Interest earned is subject to federal income taxes, but not state or local taxes.
Benefits of investing in bonds
Risks of investing in bonds
Investors can also use products like mutual funds, index funds, or exchange-traded funds (ETFs) to purchase stocks.
With these investment options, an investor can purchase shares in a fund that has pooled together stocks, bonds, and other types of securities, instead of investing in one individual company or bond. This can be a valuable and convenient option for investors who want to diversify their holdings and have greater variety in their asset allocation.
Talk with an Ameriprise financial advisor today
Because the nature of investing in stocks and bonds involves risks, there’s no one way to guarantee financial security. An Ameriprise advisor understands how these risks can affect the market and your investments, and they will work with you to create a personalized investment portfolio based on your goals, time horizon and investment risk tolerance.
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