Stocks and bonds are two of the most common things people invest in. They work in very different ways, so it helps to understand each one on its own.
What is a stock?
A stock (also called a share) is a small piece of ownership in a company.
Imagine a company has 1,000,000 shares. If you own 10 of them, you own 0.001% of the company. That is tiny, but it is real ownership.
People can earn from stocks in two main ways:
- The price goes up. If the company does well and other people want its shares, the price can rise. You could then sell for more than you paid.
- Dividends. Some companies share part of their profits with shareholders as regular payments. Not every company does this.
What can go wrong with stocks?
- The price can fall, sometimes by a lot, sometimes for a long time.
- A company can fail. If it goes out of business, its shares can become worth very little or nothing.
- Prices move up and down every day, often for reasons that are hard to predict.
What is a bond?
A bond is a loan. You lend money to a government or a company, and they promise to pay you interest and give your money back later.
A simple example: you buy a bond for 1,000 that pays 4% a year for 5 years.
- Each year you receive 40 in interest (4% of 1,000).
- Over 5 years that adds up to 200.
- At the end you get your 1,000 back.
- In total: 1,200.
What can go wrong with bonds?
- The borrower may not pay. A company or government can fail to repay. Bonds from very stable governments are usually seen as lower risk, but no investment is risk-free.
- Inflation. If prices rise faster than the interest you earn, your money buys less over time. (See What is inflation?)
- Price changes. If you sell a bond before it ends, its price can be higher or lower than what you paid, depending on interest rates at that time.
Stocks and bonds side by side
| Stocks | Bonds | |
|---|---|---|
| What you hold | A share of ownership | A loan you made |
| How you can earn | Price rises, dividends | Interest, and your money back at the end |
| Ups and downs | Usually bigger | Usually smaller |
| Long-term potential | Often higher, with more risk | Often lower, with less risk |
“Usually” and “often” matter here. Nothing about either one is guaranteed.
Why people hold both
Stocks and bonds often behave differently from each other. Holding a mix is one way people spread risk, and it is called diversification. The old saying is “don’t put all your eggs in one basket”.
What to take from this
- A stock is a piece of a company. A bond is a loan.
- Higher possible reward usually comes with higher risk.
- Spreading money across many investments reduces the damage if one of them goes wrong.
Next, read about ETFs and index funds, a simple way to hold many stocks and bonds at once.