Inevitably if you ask a finance professional (or even someone down the street) about asset allocation, they will start talking about the percentage of stocks vs. bonds in your portfolio.
But what if you don't have a good idea of what those are to begin with? This is a quick primer on the difference between stocks & bonds, and why you might want to include them in a portfolio.
What are stocks?
When people refer to "stocks", they are generally referring to common shares in a company - essentially a claim to ownership of a (very small) piece of that company.
For example, you could go to a stockbroker and purchase 10 shares of Exxon Mobil Corporation, which trades as XOM on the New York Stock Exchange. At the time of writing, these shares are trading at $95.78 USD, so purchasing 10 shares would cost you $957.80 USD.
There are 4.26 billion shares of Exxon Mobil outstanding, therefore your 10 shares represent a 0.000000235% share of ownership in the company.
Why do people invest in stocks?
There are two typical reasons why your everyday investor would buy common shares in a company:
- Participation in the company's growth Generally speaking, it is wise to invest in companies that are making profits year-on-year. As profits/assets accumulate on the company's books, the enterprise value of that company will increase. As you own a fixed percentage of the company (barring share repurchases etc.), that percentage (and therefore the price of your shares) will increase over time.
Many companies will pay a dividend (a cash dispersement) to shareholders of record one or multiple times a year. The amount of cash paid to shareholders as dividends varies greatly, but can make up a significant percentage of the expected return of holding a common share.
For example - at the time of writing, Exxon Mobil's most recent quarterly dividend was $0.69 per share. Therefore after your recent purchase of 10 common shares of XOM ($957.80), you would expect to receive $6.90 USD four times a year, or approximately $27.60 per year. This is roughly a 2.88% return on your initial investment, excluding any growth in the stock which would be above and beyond this value.
Typically, companies will try to increase their dividend payout over time, so the $0.69/quarter payout would be likely to increase as you held the stock.
What are some additional considerations in holding stocks?
There are many considerations inherent in investing in the stock market, which are beyond the scope of this document. However, some are listed here for thought:
- Equity claims on a company's assets is typically always subordinate to that of debt claims. If the company you hold shares in goes bankrupt, shareholders typically emerge with zero or very little money.
- Capital gains tax due on sale of appreciated stocks
- Stocks are typically more volatile (risky) than fixed-income assets like bonds
- Because equity ownership reaps the benefits of the business performance of a company, you are directly exposed to the business risks that company takes on. This is in contrast to debt, where you are typically only exposed to the creditworthiness of a company.
- Currency exposure for foreign stocks
- Growth vs. value. Some shares increase in value because the company is growing at a very rapid rate (and therefore has high expected future profits), whereas some increase in value due to the relative valuation of the company vs. its inherent ability to generate free cash flow.
What are bonds?
When people refer to "bonds", they are generally referring to fixed income financial products issued by companies and/or governments that represent an obligation to repay the face value at a future time, plus interest payments along the way.
For example, all of the following may be part of the fixed income portion of a portfolio:
- Government bills (maturing in less than one year)
- Government notes (maturing in 1-10 years)
- Government bonds (maturing in more than 10 years)
- Municipal bonds
- Corporate bonds (senior/junior/mezzanine)
A bond issue typically has a face value (the amount the government/company borrowed, and promises to repay), and an interest rate (the annual interest rate that the entity promises to pay to incentivize the lender to provide the bond principal).
You can hold a bond to maturity (i.e. the face value is paid back by the borrower), or you can trade them on the open market. When trading on the open market, the value of a bond will changed based on the bond's interest rate as compared to the the market's current interest rate.
Why do people invest in bonds?
Bonds can be an important part of a retirement portfolio.
If a bond is purchased with the intent to hold to maturity, they are typically purchased as they will provide known benefit, provided that the issuer does not default / go bankrupt.
If a bond is purchased with the intent of trading on the market prior to maturity, the benefit is that their value is typically less volatile than stocks (i.e. less "risky"), and are not directly correlated with the performance of stocks (provide "diversification").
What are some additional considerations in holding bonds?
There are many considerations inherent in investing in the bond market, which are beyond the scope of this document. However, some are listed here for thought:
- Return of principal is not guaranteed. The issuer can default or go bankrupt, and you would not receive all/any of your principal. (Some issuers are typically considered "risk-free" - i.e. the U.S. Government - but the same principles apply).
- The interest rate paid on a bond is typically correlated with the creditworthiness of the issuer
- The yield-to-maturity on a bond can be different than the stated interest rate, depending on the trading value of the bond on the open market
- The marginal tax rate paid on interest income is typically higher than that paid on capital gains - it may be beneficial to hold bonds in a tax-sheltered account.