What is the difference between stocks and bonds for investors?

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Answered by: Zack, An Expert in the Investing Basics Category
Two of the most basic types of investments are stocks and bonds. For new investors, learning the difference between stocks and bonds is an important start in deciding whether to invest in one or the other or both, and deciding how to balance investments.

Bonds represent a loan you make to a government, company, or other organization. Just like when you get a loan from a bank, the organization that borrows from you gets money now and promises to pay you back later with interest. The interest rate is set when you make the loan, and so is the date the payment is due (when you can get your money back). However, you can also sell your bonds to someone else, giving them the right to collect the interest later in exchange for some money right now.



By buying stocks, you own a share of a company. Instead of lending money, you're actually buying part of the company and therefore you have the right to have a (usually very small) say in how the company operates. You're also entitled to some of the company's profit when it makes money, but you can lose if it loses money. Like with bonds, you can generally sell your stocks to someone else, since even when a company's stock prices are going down you can usually find a buyer to take your shares from you at some price.

From an investor's perspective, the key difference between stocks and bonds is the relationship between risk and reward. With bonds, you don't take as much risk because there's a limit to how low their value can go. As long as whatever organization you loaned money to doesn't go broke, you're guaranteed to get back your money plus the interest rate that was agreed to when you bought the bonds. Sometimes the prices someone else will pay you might be pretty low, but if you wait until the due date you'll get the promised payment. (Because of that "unless the organization goes broke" issue, bonds issued by the US government are widely considered the safest investment in the world--the US has never failed to make these payments and has the power to increase taxes if it can't come up with the money.) However, because the amount of interest is set in advance, it's almost impossible to get a better return on bonds. If you bought a bond for $100 at a 3% interest rate, you'll get $103 when it matures, and I'm not going to pay you $104 for that bond because there's no way for me to make money on that deal. In general, the more sure you can be that you'll be paid back on the bond, the lower the interest will be since you're not taking much risk.



Stocks offer more risk in exchange for the chance at a bigger reward. If the company does badly the stock price might go down, and unlike bonds you don't have a guaranteed payback amount that you can count on. On the other hand, the price could go up much more than the interest rate you could get on a bond. Historically, investors who make good stock picks have made far more money than those who choose bonds, but bad stock choices can drive an investor into bankruptcy. Good choices in which stocks to buy are very important for investors who choose this route.

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