When building your portfolio, one of the most important decisions you’ll make is choosing investments. Though there are thousands of investment options, the two main categories that should make up the bulk of your portfolio are stocks and bonds. The key differences between these two types of investments are the level of risk they pose and how they react in various financial circumstances. Understanding the pros and cons for investing in each of these can help you make more informed decisions and create a portfolio that meets your needs.
If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.
Advantages of Investing in Stocks
In order to understand the potential advantages of stocks, it helps to understand exactly what a stock is. When you purchase stock in a company, you then own a small piece of that company. The value of your piece the company (a share) will then go up or down based on the stock price of that company. If you purchase stock at a lower price and sell it once the value of the company has increased, you will make money. If you purchase stock at a higher price and sell it after the value of the company decreases, you lose money.
The biggest advantage of investing in stocks is that stocks have more potential for reward, meaning you have the potential to make more money than you would by investing exclusively in bonds. Some stocks also pay dividends, which are distributions to shareholders paid out of some of the earnings of the company.
Disadvantages of Investing in Stocks
Stocks have more potential for reward, but with reward, comes risk. When you invest in a stock, it is possible to lose most or even all of what you invested. This is the major disadvantage of stocks—they pose a much higher risk than bonds. Within different categories of stocks, this rule of risk-and-reward balancing remains true. Stock in large companies with excellent reputations (known as blue-chip stocks) poses less risk, as a general rule, but it also does not have as much earnings potential as stock in many smaller, riskier, companies.
Stocks also have more volatility than bonds. This means that their value tends to swing up and down, as opposed to moving consistently in one direction or another. The more extreme these swings, the higher the volatility. A company with lower volatility typically has a more stable price with fewer fluctuations. Again, the amount of volatility varies depending on the type of stock being purchased.
Advantages of Investing in Bonds
A bond is a very different type of investment than stock. When you purchase a bond, you are dealing with debt. In this case, you are the lender. The borrower (the company, the government, etc.) uses the bond as a way to bring in money. In exchange for letting them borrow your money, the borrower pays you back with interest.
In this arrangement, there is still the potential of losing your investment, but the risk is usually much less than it is for stocks. This is the key advantage of bonds—less risk. When stock prices drop, being invested in bonds allows you to avoid losing as much money. This decreased amount of volatility compared to stocks means more income stability and more liquidity, all of which can be major advantages, depending on what you’re looking for in an investment.
Disadvantages of Investing in Bonds
This is where the flip side of the correlation between risk and reward comes into play. In general, bonds have less risk, but that means they also have less reward, AKA lower returns. When it comes to investing, this is obviously a huge disadvantage, since the point of investing is to increase the value of your portfolio. Increases in interest rates can also cause bond prices to drop. The disadvantages of investing in bonds may seem large, but just because bonds have potentially lower returns, doesn’t mean they don’t have a place in your portfolio.
Should You Invest in Bonds or Stocks?
Building a portfolio is not about choosing between stocks and bonds—it’s about creating the appropriate balance between stocks and bonds. With a portfolio that contains both stocks and bonds, you can be prepared for whatever the market brings. When prices fall, your investment in bonds can help defend you from massive losses. When the market grows you can see your returns increase thanks to your investment in stocks.
Work With an Experienced Financial Advisor
We hope you better understand the pros and cons for investing in stocks versus bonds. For more personalized advice on finding the right balance of stocks and bonds for your portfolio, contact the team at Good Life Financial Advisors of Mount Pleasant. We look forward to serving you!
All investing involves risk including loss of principal. No strategy insures success or protects against loss.
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.