This article is an excerpt from the Shortform book guide to "The Simple Path to Wealth" by JL Collins. Shortform has the world's best summaries and analyses of books you should be reading.
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What is the difference between stocks and bonds? How do they generate profit for investors?
The main difference between stocks and bonds is how they generate income for investors. Stocks do so by growing in value over time—they are later sold in the stock market. In contrast, bonds pay back your money plus interest over a specified period of time.
In this article, we’ll explain the basics of investing in stocks versus bonds, how they work, and what their associated risks are.
Investment Basics: Stocks vs. Bonds
What is the difference between stocks and bonds? In simple terms, stocks are shares of ownership, while bonds are effectively loans. When you buy stock, you’re buying part of a company. When you buy bonds, you’re loaning money to a company or government entity.
Investing in Stocks
To invest successfully, you must understand and accept certain truths about the market:
1) The market is the most effective wealth-building tool ever: Your money should be in the market working as effectively as possible for you as soon as possible. Collins touts Vanguard’s VTSAX Total Stock Market Index Fund as the simplest and most effective investment for tapping into the market’s wealth-building capabilities. (Collins notes that he isn’t being paid by Vanguard to promote its funds.)
2) The market always goes up over time: You can predict that it will be higher in 10-20 years than it is today. It’s been on an upward trajectory for 120 years. The Dow Jones Industrial average started the last century at 68 and ended at 11,497 (in 2010). As investor Warren Buffett has pointed out, this period included two world wars, a depression, periods of high inflation, oil shocks, and a dozen recessions and financial panics. Despite dips, the market maintains an overall upward trajectory.
3) The market is volatile: Market crashes (drops of 20% or more) are inevitable—a major plunge typically occurs about every 25 years, plus there are more frequent smaller drops in that timeframe as well as several bull (increasing) markets. There’s always a major crash somewhere ahead—for example, on October 19, 1987, on Black Monday, the market suddenly dropped 22% or 500 points. In addition, even bigger disastrous events like the 1929 Great Depression are part of the predictable process.
4) Investing successfully requires accepting risk and having the discipline to stay the course during downturns: To succeed as an investor, you’ll have to prepare yourself intellectually and emotionally for downturns and tough them out. If you panic instead and sell, you’ll lose.
Investing in Bonds
Although bonds are viewed as steadier than stocks, they have several risks:
1) Default risk: The biggest risk is that the bond issuer will default and not pay you back. To help investors determine default risk, bond rating agencies (the primary ones are Standard & Poor’s Global Ratings, Moody’s, and Fitch Ratings) rate bonds based on creditworthiness. The scale ranges from AAA at the top to D.
The lower a bond’s rating, the higher the risk of default. Default risk is a key factor in the interest a bond pays. Poorly rated bonds are harder to sell, so the borrower or issuing agency offers higher interest to make them more attractive to buyers; investors get more interest when they assume more risk. All the bonds in VBTLX are highly rated, with none lower than Baa, which reduces the default risk.
2) Interest rate risk: Besides default, another risk of bonds is interest rate risk. This is only a factor if you decide to sell a bond before the maturity date (the end of its term). To sell it, you have to offer it to buyers in the so-called secondary market.
Whether you get more or less than you paid for the bond depends on how much interest rates have changed since you bought it. If they’ve gone up, the value of your bond will have decreased because investors won’t want to buy a bond that pays a lower rate. If interest rates have gone down, the value of your bond will have increased and you can get more than you paid for it (it’s a better deal than bonds currently being sold at lower rates). Either way, if you keep a bond until it matures, you’ll get what you paid for it as long as the borrower doesn’t default.
3) Term risk: The third risk factor for bonds is term risk. Along with default risk, the term of a bond factors into its interest rate. The longer a bond’s term, the more likely interest rates will change before it matures, and therefore, the greater the risk it will lose value if you want to sell it. So longer-term bonds pay higher interest than shorter-term bonds. The latter don’t tie up your money as long, so there’s less risk of interest rates changing.
Interest (yield) and terms for bonds can be graphed on a “yield curve.” The bigger the difference between short- and long-term bond interest rates, the steeper the curve. When short-term rates become higher than long-term rates, you get an inverted yield curve, which isn’t welcomed because inverted yield curves are typically followed by recessions.
4) Inflation risk: Inflation (when prices are rising) is the biggest risk for bonds. When you buy a bond (loan money) during an inflationary period, it will be worth less (buy less) when the borrower pays it back. Expected inflation also factors into the interest rate paid on a bond. As previously noted, long-term bonds, which are most likely to be affected by inflation, pay the highest interest. VBTLX reduces the inflation risk for investors because the bonds in the fund have a broad range of terms (the risk is spread out).
5) Other risks include:
- Credit downgrades: When rating agencies downgrade a company’s or agency’s bond rating due to financial problems, the bond’s value decreases.
- Callable bonds: Bond issuers can pay off callable bonds before the maturity date (meaning they give your money back and stop paying interest). They do this when interest rates are falling and they can borrow more cheaply by issuing new, lower-rate bonds. As previously explained, when rates fall, the value of your bond goes up—but that won’t benefit you if it’s recalled.
- Liquidity risk: If a company and its bonds fall out of favor with investors—for instance, by getting into legal trouble—this creates liquidity risk, which means that if you want to sell your bond, you’ll find few takers and will get a lower price.
The best way to buy bonds is to invest in a bond index fund. Bonds carry some risks, which we’ll explain in a moment, so most people don’t buy individual bonds except for U.S. Treasury Bonds.
Buying bonds via the VBTLX, Vanguard Total Bond Index Fund, mitigates the risks of owning individual bonds because the fund holds around 8,000 bonds, and a problem with one bond won’t have much impact. All of them are high-quality bonds and their terms vary over a broad range.
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- A simple road map to achieving financial independence and a secure retirement
- How to put your money to work for you as your “servant”
- Why you don't need a financial advisor to help you invest