One of the questions that a beginning investor may ask is, what is the difference between stocks and bonds? Another question may be why it is important to have both of them in your portfolio. The question isn’t stocks vs bonds: an investment portfolio to be properly diversified should contain a mixture of both stocks and bonds. The question is merely, “how much of each?”
Both stocks and bonds are issued by a company to raise capital. Stocks are an actual investment in the company. They represent a portion of ownership in that company. When you own stock in a company you own the right to participate, to a point, in the decision making of the company. This is done by the right to vote on the officers of the company. You will also have the right to vote on major changes in how the company conducts their business at their annual meetings. When you own stock in a company you also can participate in the growth of the company in two ways. The first way is that as the company generates profit, the price of their stock will increase, and the value of your investment will go up. The second way is, if the company decides to distribute their profits in the form of dividends, then you as a stockholder qualify for a portion of those dividends.
Bonds are a loan to the company. When you buy bonds you obtain a right to a stated amount of interest which is paid when you redeem the bond. This may be at the bond’s maturity or at some time before the maturity. Bonds do not allow you to participate in the decision making of the company. They also do not increase in value if the company grows in value. However, they also are not subject to the risks that come with ownership in stocks.
It is wise to have a mixture of bonds and stocks because of risk management principles. Bonds offer a form of low risk and serve to balance the risk that comes with ownership of stocks. You purchase stocks for the possibility of high returns, and you purchase bonds to reduce that risk. Index investing is the preferred way to own both stocks and bonds.