Stocks vs bonds: what's the difference?

Ownership vs lending

Stocks vs bonds is the most basic choice in investing, and it comes down to one question: do you want to own, or to lend?

Stocks (also called shares or equities) give you a small piece of a company. If the company grows its profits, your share can become worth more, and it may pay you part of the profits as a dividend. If the company struggles, your share can fall in value, and if it fails, you can lose everything you put in. Owners are paid last.

Bonds are loans. When you buy a bond, you lend money to a government or company for a set period. In return you usually get a fixed interest payment, called the coupon, each year, and your original amount, called the face value, back when the bond matures (ends). Lenders are paid before owners, which makes bonds less risky, but your upside is capped at the agreed interest.

Risk and return

ESMA, the EU's markets regulator, sums it up: potentially greater returns come with greater risk. Stocks and bonds are the clearest example.

Vanguard's 2023 research on world stocks (the MSCI World Index) and US bonds from 1976 to 2022 shows the trade-off over one-year periods, starting from $100,000:

More stocks meant higher typical returns, but deeper falls in bad years. More bonds meant a calmer ride with less growth. The same paper notes that over this period, US stocks beat cash 76% of the time and US bonds 68% of the time.

These are past results, measured over single years. They don't predict the future.

How bond prices move with interest rates

This is the part of bonds most people find confusing. FINRA, the US investor protection body, puts the rule simply: when interest rates fall, bond prices rise, and vice versa.

Here's why. Say you own a bond that pays 3% a year. Then interest rates rise, and new bonds pay 4%. Nobody will pay full price for your 3% bond when they can get 4% elsewhere. So if you want to sell, the price has to drop until the buyer's return matches the new rate.

Two things stand out. First, the longer the bond has left, the more its price moves. FINRA explains this with duration, a measure of how sensitive a bond is to rate changes: a duration of 10 means the price moves roughly 10% for each 1 percentage point change in rates. Second, if you hold the bond until it matures, the price swings along the way don't change what you get back, as long as the borrower pays.

Bond funds are different: they don't mature, so a rise in rates shows up directly in the fund's price, though the fund also starts buying new, higher-paying bonds.

Mixing stocks and bonds

Most investors don't choose one or the other. They choose a mix, called an asset allocation. A common example is 60/40: 60% stocks for growth, 40% bonds for stability.

Imagine €10,000 split 60/40, and a bad year where stocks fall 30% and bonds rise 2%:

• Stocks: €6,000 becomes €4,200.
• Bonds: €4,000 becomes €4,080.
• Total: €8,280, a fall of 17.2%.

The same year with all stocks would leave €7,000, a fall of 30%. Bonds don't always rise when stocks fall, though. In some years both have fallen together, especially when interest rates rose quickly.

Over time, the mix drifts as one part grows faster. Many investors rebalance once a year: selling a little of what grew and buying what lagged, to get back to their chosen mix.

Age-based allocation: an example, not a rule

You may come across rules of thumb like "hold your age in bonds" or "100 minus your age in stocks". At 30, that would mean 70% stocks and 30% bonds; at 50, 50% of each.

The idea is that younger people have more time to recover from falls, and older people closer to needing their money want more stability. Some funds, often called target-date or lifecycle funds, shift the mix automatically as a chosen date gets closer.

Treat these as examples, not advice. The right mix depends on when you need the money, what else you own, whether you have a pension, and how you'd behave in a crash. ESMA suggests starting with your goals and time horizon, and getting help from a trusted professional if a product is unclear.

Common mistakes

• Treating bonds as cash. Bond funds go up and down. Your emergency fund belongs in a savings account. Our emergency fund guide explains how much to keep.
• Holding only stocks for a short-term goal. If you need the money in two years, a fall could leave you short.
• Holding only bonds for a 30-year goal. Lower risk can also mean much less growth, especially after inflation.
• Never rebalancing. After a long run of rising stocks, your 60/40 mix can quietly become 75/25.
• Chasing high bond yields. A bond paying far more than others usually does so because the borrower is riskier.

Both stocks and bonds are easy to hold through low-cost funds. Our guide to what an ETF is covers stock and bond ETFs, and our investing for beginners guide shows where the mix fits in.