{"id":48091,"date":"2021-09-12T17:51:00","date_gmt":"2021-09-12T21:51:00","guid":{"rendered":"https:\/\/www.shortform.com\/blog\/?p=48091"},"modified":"2021-09-14T15:35:31","modified_gmt":"2021-09-14T19:35:31","slug":"what-is-the-difference-between-stocks-and-bonds","status":"publish","type":"post","link":"https:\/\/www.shortform.com\/blog\/what-is-the-difference-between-stocks-and-bonds\/","title":{"rendered":"What Is the Difference Between Stocks and Bonds?"},"content":{"rendered":"\n

What is the difference between stocks and bonds? How do they generate profit for investors?<\/p>\n\n\n\n

The main difference between stocks and bonds is how they generate income for investors. Stocks do so by growing in value over time\u2014they are later sold in the stock market. In contrast, bonds pay back your money plus interest over a specified period of time.<\/p>\n\n\n\n

In this article, we’ll explain the basics of investing in stocks versus bonds<\/a>, how they work, and what their associated risks are. <\/p>\n\n\n\n\n\n\n\n

Investment Basics: Stocks vs. Bonds<\/h2>\n\n\n\n

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\u2019re buying part of a company. When you buy bonds, you\u2019re loaning money to a company or government entity.<\/p>\n\n\n\n

Investing in Stocks<\/h3>\n\n\n\n

To invest successfully, you must understand and accept certain truths about the market:<\/p>\n\n\n\n

1) The market is the most effective wealth-building tool ever:<\/strong> 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\u2019s wealth-building capabilities. (Collins notes that he isn\u2019t being paid by Vanguard to promote its funds.)<\/p>\n\n\n\n

2) The market always goes up over time: <\/strong>You can predict that it will be higher in 10-20 years than it is today. It\u2019s 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.<\/p>\n\n\n\n

3) The market is volatile: <\/strong>Market crashes (drops of 20% or more) are inevitable\u2014a 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\u2019s always<\/em> a major crash somewhere ahead\u2014for 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<\/a> are part of the predictable process. <\/p>\n\n\n\n

4) Investing successfully requires accepting risk and having the discipline to stay the course<\/strong> during downturns:<\/strong> To succeed as an investor, you\u2019ll have to prepare yourself intellectually and emotionally for downturns and tough them out. If you panic instead and sell, you\u2019ll lose. <\/p>\n\n\n\n

Investing in Bonds<\/h3>\n\n\n\n

Although bonds are viewed as steadier than stocks, they have several risks:<\/p>\n\n\n\n

1) Default risk:<\/strong> 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<\/a>) rate bonds based on creditworthiness. The scale ranges from AAA at the top to D.<\/p>\n\n\n\n

The lower a bond\u2019s 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. <\/p>\n\n\n\n

2) Interest rate risk:<\/strong> Besides default, another risk of bonds<\/a> 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. <\/p>\n\n\n\n

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\u2019ve gone up, the value of your bond will have decreased because investors won\u2019t 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\u2019s a better deal than bonds currently being sold at lower rates). Either way, if you keep a bond until it matures, you\u2019ll get what you paid for it as long as the borrower doesn\u2019t default.<\/p>\n\n\n\n

3)<\/strong> Term risk:<\/strong> 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\u2019s 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\u2019t tie up your money as long, so there\u2019s less risk of interest rates changing.<\/p>\n\n\n\n

Interest (yield) and terms for bonds can be graphed on a \u201cyield curve.\u201d 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\u2019t welcomed because inverted yield curves are typically followed by recessions.<\/p>\n\n\n\n

4)<\/strong> Inflation risk:<\/strong> 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).<\/p>\n\n\n\n

5) Other risks<\/strong> include:<\/p>\n\n\n\n