Stocks and bonds are two important components of financial portfolios. They both represent different types of investments, and understanding their differences is essential to making informed investment decisions. You should also consider the risks associated with each type of investment.
What are Stocks?
Stocks represent ownership in a company. When you buy stocks, you become what is known as a shareholder and own a small piece of a publicly traded company. Investors typically hope that the stock they buy increases in value over time, allowing them to make money when they sell it.
Risks Associated with Stocks
Stocks are considered to be riskier investments than bonds due to their potential for larger swings in value. If the company whose stock you buy does not perform as expected, its stock price can decline quickly and dramatically.
Here are some categories of risks associated with stocks:
- Company Risk – When you invest in a specific company's stock, you risk the company suffering financial losses or other problems.
- Volatility Risk – A stock's price can fluctuate wildly over a short period, resulting in large gains and losses. Consequently, there is always the risk of losing money even if a particular stock's long-term trend is positive.
- Obsolescence Risk - Think of a company such as Kodak that didn't keep up with digital photography technology. A company can become obsolete over time, thus affecting its stock’s performance.
- Market Risk – The risk that the overall stock market will decline. This can cause all investments, including stocks, to lose value.
What are Bonds?
Bonds are debt investments in which an investor loans money to a company, government, or other entity for a set period. An entity issues bonds in exchange for the loan and pays interest payments over the bond's life. At the end of the bond's term, known as maturity, the issuer repays investors their principal.
Risks Associated with Bonds
There is less risk associated with bonds than stocks because the bond issuer typically has a greater incentive to repay investors' money than a company has to increase its stock price.
- Liquidity Risk - Bond markets are not as liquid, meaning that it may be difficult or take a long time to get your money out of the investment.
- Interest Rate Risk Diversification - Bonds typically pay a fixed rate of interest. If the prevailing interest rates go up, investors may find that their bonds are not attractive investments because they pay a lower rate than newer bonds.
- Default Risk - The risk that an issuer of bonds will not be able to make interest payments or repay the principal at maturity.
Having a balance of stocks and bonds in your financial portfolio is essential. The stock market can be volatile and risky but also offer higher returns. On the other hand, bonds are generally less risky but provide lower returns.
Bonds represent a debt investment, while stocks represent an equity investment. Understanding the risks associated with each type of investment is important to make informed decisions when building a portfolio. Having a balance of stocks and bonds can help you achieve your financial goals for the long term.