Stocks vs. Bonds: A Beginner’s Guide

If you want to get started investing, it’s important to know the ins and outs of stocks and bonds—the basic building blocks of most Americans’ portfolios.

About six in 10 adults report owning stocks, which represent your own sliver of ownership in a corporation, like Apple or Starbucks, and let you benefit from its growth as the stock’s price rises in value. 

Far fewer people own bonds, a type of fixed-income investment that represents your share in a loan made to a company, government or other entity. Still, bonds’ returns are more predictable than stocks’ and allow you to collect interest, generating a steady stream of income. 

“Historically, investors who have both stocks and bonds benefit,” says Jonathan Lee, a St. Louis-based financial planner at U.S. Bank Wealth Management. “They have the relative safety of bonds and the higher return potential of stocks.” 

Of course, neither stocks nor bonds are risk-free. Still, some of the risks, such as price volatility, can be lessened by investing in mutual funds, which pool individual stocks and bonds. Whether you should own more stocks or bonds in your portfolio depends largely on the timing and cost of your financial goals and how comfortable you are with risking your money.

Here’s what to know about the difference between stocks and bonds, how to buy them and how your profits are taxed.

What are stocks?

Stocks, also known as equities, give investors an ownership share of a company. When a company performs well, its stock price generally rises. That capital appreciation is one of the main reasons stocks help investors build wealth. Some companies also share profits with their investors through regular payments called dividends. 

While many investors are attracted to stocks for their seemingly limitless potential for growth, stocks can lose value too—and fast. To make money with stocks, investors have to be willing to stomach risk. 

The stock market, on average, returns about 10% a year. But returns in individual years are often much higher or lower—the S&P 500 dropped more than 18% in 2022—but the upshot is that investors who stay in the market for a long time can make a solid return on their investment. 

“When investing in stocks, your goal is usually price appreciation—you are hoping you can sell a share of stock for more than you paid for it,” says Laurie Itkin, a financial advisor and wealth manager at Coastwise Capital in San Diego. But be “prepared to withstand the roller coaster of price swings, corrections and bear markets,” Itkin says.

Types of stocks

Stocks can be categorized in a few different ways that reflect the types of companies they represent or how investors earn money. 

• Growth stocks are companies whose earnings, revenue or sales are growing faster than the market average. Investors who buy growth stocks expect their price to continue increasing and will accept a higher level of risk in exchange for a potentially higher return. Amazon, Google-parent Alphabet, Facebook-parent Meta and Tesla are examples of growth stocks. 
• Value stocks are typically cheaper than growth stocks. Essentially, it’s a stock that investors believe is underpriced relative to its track record and will rebound in the future. Examples include older, established companies such as Procter & Gamble and Target.
• Income stocks pay dividends to shareholders. Income stocks are generally lower risk—and thus, lower reward—than growth stocks, but can still generate modest appreciation over time, in addition to paying dividends. Examples include Walmart and Microsoft.
• Large-cap stocks are companies with a total value of outstanding shares, known as market cap, of $10 billion or more. These stocks make up the S&P 500 and Russell 1000 indexes.
• Midcap stocks are companies with a market cap between $2 billion and $10 billion. They’re represented on the S&P 400 index.
• Small-cap stocks are companies with a market cap between $250 million and $2 billion. The Russell 2000 is a small-cap index.

In recent years, the advent of fractional shares has allowed investors to buy less than a full share of stock. It’s useful if a stock is too expensive but you still want to include it in your portfolio. Fractional shares can be purchased for as little as $5. 

What are bonds?

When you buy a bond, you’re buying a piece of a company’s debt and collecting interest, or coupon payments. On the bond’s maturity date, the company will give you the face value, or “par” value, of the bond (which doesn’t always match the price you paid.) The primary goal of owning bonds is to earn consistent income, Itkin says. This is why they’re called fixed-income investments.

Rather than betting that a company’s sales or revenue will remain steady or grow, as with stocks, when you buy a bond you’re betting that a company can simply continue paying its debts. Companies with higher credit ratings have a higher likelihood of paying their bills and tend to issue investment-grade bonds. Companies with lower credit ratings issue so-called junk bonds, which carry a lot more risk, but usually have a higher yield.

A bond’s value may fluctuate while you own it, but it’s different from a stock. If you hold the bond until its maturity date, you’ll still earn the same amount of interest. 

The summer average bond yields—essentially market’s prevailing interest rates—are down slightly from a year ago, with investment-grade corporate bonds returning about 5.6% and government bonds returning roughly 5%.

Types of bonds

There are three main types of bonds to invest in:

• Municipal bonds, or munis, are issued by state, city and local governments. These are high-quality bonds—although they’re not guaranteed to be repaid to investors.
• Government bonds, or Treasurys, are high-quality bonds, backed by the full faith and credit of the federal government, that promise to repay principal and interest to investors if they are held to maturity. Itkin says these are safer “than lending money to your brother-in-law.”
• Corporate bonds are the riskiest type of bond because they’re issued by private and public companies that can fail to pay back their debt. It’s important to pay attention to the aforementioned credit ratings when you’re choosing a corporate bond. Corporations issue bonds for various reasons, such as when they need to invest in research and development, buy new equipment, refinance existing debt or fund an acquisition.

While government bonds are virtually risk-free—the chances of the U.S. defaulting on its debt are slim to none—they are still sensitive to inflation and changing market conditions. The longer the bond’s term—that is, the specified length of time before the borrower pays back bondholders—the greater the risk.

Bonds are useful as a counterweight to the rapid price swings of stocks, but generally should not make up your entire portfolio. Bonds are not as easily tradable as stocks, in part because they don’t trade on exchanges and in part because each bond has a unique term to maturity. During that time, changing interest rates can affect the price of a bond. If an investor wants to sell a bond before its maturity date and is able to find a buyer on the much thinner market for bonds, they may not make their initial investment back.

Another downside to note: Corporate bonds include a call feature, meaning the company can decide to repay your principal early, cutting off your cash flow. This usually happens when interest rates are falling and companies want to issue new bonds to pay a lower interest rate on their debt. 

Investing in stocks and bonds

Most investors need to own both stocks and bonds to build wealth over time, but your age and the timing of your financial goals will help determine the best mix for you. 

One key benefit of holding a stock-and-bond mix: Their performance is inversely related, meaning the value of one is usually up when the other is down. When the economy is doing well, Lee says, people tend to take on more risk, driving up stock demand—and by extension, stock prices. 

In a struggling economy, people rush into safer investments, like bonds and cash, causing stock prices to drop, sometimes sharply and with little warning. If you own both stocks and bonds, then at any given time one part of your portfolio will be surging ahead, while the other lags behind—but the overall effect will be to reduce volatility and smooth your long-term returns.

Finding the right balance of stocks and bonds for your age

Because stocks are more volatile overall, retirees and other investors who need to tap their portfolio for income in the near future usually benefit from a more conservative approach—meaning more of their money should be more in bonds than stocks to smooth out some of the potential volatility. 

Investors with a lot of runway—an early career professional with decades until retirement or a parent starting a college fund for their toddler, for example—can afford to be more aggressive and keep a higher share of their portfolio invested in stocks than bonds.

Take a look at the following data from Vanguard showing the historical returns of different stock and bond combinations over time. 

If simplicity is your style, consider a target-date fund. These all-in-one funds are a mixture of stock funds and bond funds that move along a glide path to become more conservative the closer you get to your goal date, says Lee. That usually means increasing bondholdings and decreasing stockholdings. Target-date funds aren’t for everybody, but they can be an easy solution for someone with specific retirement and college planning needs and little interest in devising their own investment strategy.

How to buy stocks and bonds

You likely already own stocks and bonds if you have money in a 401(k) or 403(b) retirement plan through work. These are special investment accounts that allow you to defer taxes on your investment profits until retirement. 

Many companies now automatically enroll employees in retirement plans unless they manually opt out (auto-enroll will be required by law starting in 2025). If you aren’t signed up for your plan yet, you can do so by contacting your company’s human resources department. 

To buy stocks and nongovernment bonds outside of a workplace retirement plan, you can open a brokerage account for free through an investment firm (Treasurys need to be purchased through a TreasuryDirect account). 

Many of the firms that service corporate retirement plans, like Fidelity, Schwab and Vanguard, also operate some of the best online stock trading platforms for individual investors, where you can build and manage a portfolio of stocks, bonds and other assets, or hire a professional to do it for you.

For an even simpler approach, consider robo-advisors like Betterment or Wealthfront. These platforms are a good solution for investors who don’t have the time or interest to trade stocks and bonds and prefer investing in funds. A robo-advisor will quickly build a portfolio for you based on its own market research, as well as your financial goals and risk tolerance. The plug-and-play nature of these platforms means they’re generally the lowest-cost option. Plus, many robo-advisors also employ automated tax-saving tools.

Once you decide on an investment platform, you need to pick an account type. An individual retirement account, or IRA, gives investors who want to save money for retirement outside of work the ability to buy stocks, bonds, mutual funds and other assets. IRAs come with possible tax benefits too, including an income tax deduction and tax deferment investment profits. Another popular investment account is the 529 college savings plan, where you can invest money in stocks and bonds to pay for a child’s education. 

Bond funds vs. stock funds

Instead of buying individual stocks and bonds, you can save a lot of time and stress by purchasing a stock or bond fund. 

Funds hold many securities that are driving toward a similar goal. In a stock fund the objective could be long-term growth or steady dividend income, and the fund might target a specific industry like tech or energy. If a fund is actively managed, an advisor is tasked with ensuring that all of the underlying stocks in the fund are contributing to the objective. Or the fund may simply track an index that doesn’t require a professional stock picker to manage it. Just like individual stocks, stock funds can pay dividends. 

Most bond funds are made up of either corporate or government bonds but some funds include both. A bond fund is actively managed by a professional advisor, which can be appealing to investors because trading individual bonds is expensive and inconvenient. But the funds don’t work exactly the same as owning a single bond. 

A bond pays a fixed rate of interest on a predictable schedule until the bond matures; a manager of a bond fund may buy or sell the underlying bonds in its portfolio, affecting how much interest is paid out to investors.

Importantly, funds are a way for investors to instantly diversify their portfolio by spreading their risk among many different companies, says Lee. That’s why they’re often used in workplace retirement plans and by robo-advisors, which favor streamlined investing approaches.

Stock taxes vs. bond taxes

It’s important to understand how the money you earn from stocks and bonds is taxed. Factoring in taxes helps you figure out your actual investment return.

Bond taxes

Bonds generate income in the form of interest payments. Whether you owe taxes on that income depends on the type of bond you have. Here are the general rules: 

• Muni bond interest is not subject to federal income taxes. Oftentimes it will also be exempt from state income tax by the issuing state.
• Government bond interest is taxable at the federal level but exempt at the state level.
• Corporate bond interest is fully taxable as income by both federal and state governments. 

However, there is a loophole: If you hold bonds in a retirement account, such as a 401(k) or IRA, where the interest income accumulates but isn’t withdrawn, you won’t owe taxes until retirement. 

Stock taxes

The profit you earn from selling a stock for more than you bought it for is called a capital gain. If you hold the stock for less than a year, your profit is considered a short-term capital gain and it’s taxed as ordinary income (the same as your bond interest).

Profits from stocks held longer than a year, or long-term capital gains, are subject to a separate tax rate, either 0%, 15% or 20%. You pay the same rates on qualified dividends, while ordinary dividends are taxed as regular income. 

Your capital-gains rate depends on your income level. In general, capital-gains tax is favorable—you likely won’t pay more than you would on your ordinary income. In 2023, you need to earn $44,626 as a single tax filer, or $89,251 if you’re married, to owe any capital-gains tax. The same tax loophole that applies to bond income in a retirement account applies when you invest in stocks.

Brokerage accounts don’t shelter you from taxes like retirement-oriented accounts do, but there are still some tax-related benefits, including the ability to offset your gains by your losses, leading to a smaller tax bill.

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