Understanding the Differences Between Bonds and Stocks

The stock market consists of exchanges and over-the-counter markets where publicly held companies' stock shares and other financial instruments are traded. Stocks represent ownership in a company, giving investors a stake in its profits and losses. On the other hand, bonds are debt securities issued by corporations or governments to raise capital. When you buy a bond, you are essentially lending money to the issuer in exchange for periodic interest payments and the return of the principal amount at maturity.

The Federal Reserve just raised interest rates — again. On Wednesday, the central bank announced another quarter-point hike for the federal funds rate. This move can have a significant impact on both the bond and stock markets. When interest rates go up, bond prices typically fall, as new bonds issued at higher rates become more attractive to investors. Conversely, rising interest rates can also lead to a decrease in stock prices, as borrowing costs for companies increase.

Debt and equity are broad terms for two categories of investments bought and sold. The debt or bond market is where loan assets are bought and sold. Bonds are generally considered less risky than stocks, as they have a fixed maturity date and interest rate. Stocks, on the other hand, represent ownership in a company and are subject to market fluctuations. When you add bonds to your portfolio, you get more predictable returns and less volatility.

You might think the stock market is huge, but the bond market is even bigger. According to the Securities Industry and Financial Markets Association (SIFMA), the global bond market is valued at over $100 trillion, compared to the stock market's $64 trillion. Bonds can be bought through an online broker, an ETF or directly from the U.S. government. Bond ETFs can provide diversified exposure to the bond market, making it easier for individual investors to access this asset class.

Economists have long observed that the broader economy is more closely linked to the bond market than to the stock market. Changes in interest rates, inflation expectations, and economic growth can all impact bond prices and yields. In contrast, stock prices are influenced by company-specific factors, market sentiment, and industry trends. So far in 2022, both the stock and bond markets have posted serious losses. To find another market that looks like this one, you'd have to go back to the financial crisis of 2008.

How have investment returns for different portfolio allocations of stocks and bonds compared over the last 90 years? Research shows that a balanced portfolio of stocks and bonds has historically provided higher returns with lower volatility than investing solely in stocks. By diversifying your investments across asset classes, you can reduce risk and improve your chances of long-term financial success.