Stocks and bonds have advantages and disadvantages when building an investment portfolio. Much of this depends on your risk tolerance and how you construct your investment strategy. When considering the potential risks and rewards of stocks and bonds, it is important to first learn the key differences between them.
Stocks are ownership in a company, and bonds are a loan to a company or the government. Historically stocks have generated higher returns than bonds. According to the U.S. Securities and Exchange Commission (SEC), the stock market has had annual returns of about 10% over the long term. The annual return on investment for bonds is about 5%.
Stocks also have significantly more risk than bonds. They can go up and down with the market but also fluctuate for other reasons, including factors unrelated to the company's business. In contrast, bonds are a debt security and a safer investment choice.
Stocks and bonds often play unique but crucial roles in a diversified portfolio. Here are a few pros and cons to consider when deciding which type of investment would work for you:
Pros and Cons of Owning Stocks
· Long-term gains – Stocks have the potential to generate higher returns, but this comes with risk.
· Dividend payments – A distribution of earnings by a company to its shareholders in the form of cash or stock reinvestment.
· Market liquidity – An individual or firm can sell or purchase an asset reasonably quickly without the price changing significantly.
· Diversification – A diversified portfolio, for example, investing in the S&P 500, allocates your capital and lowers your risk exposure in any asset.
· Grow with the economy – Stocks tend to grow in a prosperous (bull) market; companies have more wealthy, and investors become more confident.
· Risk – It is impossible to predict how the market with fluctuate or how companies will perform over any length of time. A stock that has done well in the past, won’t necessarily match that in the future. Stocks are particularly susceptible to loss in the short term.
· Gains are taxed – Stock market gains are generally taxable when you sell your position. If you have held the stock for less than a year, the gains will be taxed at your ordinary tax rate. If you hold a stock longer than a year, you are taxed at the capital gains tax amount, which is lower than the ordinary tax rate.
· Emotional investing – Panic selling during a downturn or enthusiastic buying in a bull market can be risky. Be careful not to allow emotions to influence your investment strategy.
· Stockholders get paid last – Should a company go under, common stockholders are the last to get paid if any money is left over after paying back the debt holders, creditors, bondholders, and preferred stockholders.
· Potential cost of time-consuming research – Deciding which stocks to buy with your hard-earned money takes significant research and this can become time-consuming when you could be spending your time on something else. All the time spent researching might not generate any returns at all.
Pros and Cons of Owning Bonds
· Preservation of capital – Bonds are a way of preserving capital as they pay interest, and if they are held to maturity, bondholders can receive back the entire principal.
· Steady income stream – Most bonds have a fixed coupon payment that pays every six months.
· Exempt from income tax – Depending on the type of bond you invest in, the income from the fixed amount of interest paid may be tax-free.
· Exempt from state and local taxes – Bonds issued by the federal government and its agencies are generally exempt from local and state taxes.
· Interest rate risk – If interest rates rise above the locked-in rate at the time of purchase, the bond price falls.
· Liquidity risk – Bonds can’t always be liquidated instantly as some bonds are easier to trade than others. Difficulty in trading an investment may be due to price volatility or some issue with the number of buyers and sellers. Because of this, the bond liquidity declines.
· Credit risk – The risk that the bond issuer may default on one or more payments before the bond reaches maturity.
· Call risk – Callable bonds carry more risk than non-callable bonds because an investor who has a bond that was called may face reinvesting the money at a lower rate.
· Inflation risk – Because bond payouts are generally based on fixed interest rates, they may be subject to inflationary risk because a rise in inflation diminishes their purchasing power.
Investing in stocks and bonds can be difficult and risky, but it can be beneficial when done carefully. Consulting a financial professional regarding your financial situation and investing interests can help mitigate unwanted risks and help you align with your financial goals.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. All indexes are unmanaged and cannot be invested into directly.
Past performance is no guarantee of future results.
Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.
This article was prepared by LPL Marketing Solutions
Sources: Bonds vs. Stocks: What's the Difference? | The Motley Fool Pros and Cons of Buying Stocks - Experian Stocks vs. Bonds: What’s The Difference? – Forbes Advisor Bonds | Investor.gov Dividends: Definition in Stocks and How Payments Work (investopedia.com) Preferred vs. common stock: What's the difference? | Fortune Recommends Guide to Investment Bonds and Taxes - TurboTax Tax Tips & Videos (intuit.com) How government bonds are taxed | Vanguard Bond Liquidity—Factors to Consider and Questions to Ask | FINRA.org Callable or Redeemable Bonds | Investor.gov
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