Stocks vs Bonds: Key Differences and Why Governments and Companies Use Them Differently

Hello, Elephants!

If you’ve ever wondered what the difference is between stocks and bonds, you’re not alone. These two investment options are often talked about together, but they work in completely different ways. Think of stocks as owning a piece of a company—like having a small slice of the cake. If the company does well, your slice becomes more valuable, and you could make money by selling it for a higher price or through dividends. On the other hand, bonds are like lending money to a company or government. In return, they promise to pay you regular interest and give your money back when the bond “matures,” like getting your loan repaid.

In this article, we’ll explore the key differences between stocks and bonds, why governments and companies use them differently, and how both have performed over the past 30 years. By the end, you’ll have a clearer picture of how they fit into your investment journey!

Let’s dive in!

What is the Difference Between Stocks and Bonds?

When it comes to investing, stocks and bonds are two of the most common tools you’ll hear about. They both play a key role in growing your wealth, but they work in very different ways. Let’s break it down.

Stocks: Ownership in a Company

When you buy stocks, you’re essentially buying a small piece of a company—this is called equity. Imagine the company as a giant pie, and each stock you own is a slice of that pie. The more shares you hold, the bigger your slice. If the company does well—grows, makes profits, and increases in value—your slice also becomes more valuable. You can make money in two main ways:

1. Selling the stock at a higher price than what you paid for it. This is known as capital appreciation. For example, if you bought shares at £50 each and the company’s stock price rises to £75, you could sell them for a £25 profit per share.
2. Dividends. Some companies share their profits with stockholders by paying them regular amounts, known as dividends. The more shares you own, the more dividends you’ll receive.

However, stocks can be risky. Stock prices fluctuate based on how well the company is doing, as well as external factors like the economy or market conditions. If the company underperforms or goes bankrupt, your shares could lose value, and you might end up selling them at a loss. This is why stocks are considered higher-risk investments—but they also offer higher potential returns if things go well.

In summary, stocks give you part-ownership of a company, and if the company thrives, you do too. But if things go south, so does the value of your shares.

Bonds: Lending Money for Interest

On the flip side, bonds are a form of debt. When you buy a bond, you’re essentially lending money to a company or a government. In return, they promise to pay you regular interest payments over a set period and return your original investment (called the principal) once the bond reaches its end date, or “matures.”

Unlike stocks, bonds don’t give you ownership in the company or government. Instead, you act like a lender, and the company or government owes you money. Here’s how you benefit:

1. Fixed interest payments. Bonds pay you interest on a regular schedule—usually annually or semi-annually—so you get a reliable source of income. For example, if you invest £1,000 in a bond with a 5% interest rate, you’d receive £50 every year until the bond matures.
2. Return of your initial investment. When the bond matures, the issuer (whether it’s a government or company) repays you the full amount you invested.

Bonds are generally less risky than stocks because they offer fixed returns. You know exactly how much interest you’ll earn and when. Plus, if the issuer is a government (especially a stable one like the UK or US), the risk of default (not getting paid back) is very low. That said, corporate bonds (those issued by companies) can carry more risk, especially if the company has financial troubles.

However, because they are safer, bonds typically offer lower returns compared to stocks. You’re unlikely to see the same growth potential as you would with shares in a rapidly expanding company.

Here’s a simple way to think about it: stocks are like riding a rollercoaster—there are ups and downs, and you might make a lot or lose a lot. Bonds, on the other hand, are more like a steady bus ride—it’s slower, but you’re more likely to arrive safely at your destination.

As TD Bank puts it, “Stocks are ownership shares in a company, while bonds are a kind of loan from investors to a company or government.”

Stocks vs Bonds: Risk and Return

One of the biggest differences between stocks and bonds is the risk and return profile. Stocks, while potentially more profitable, come with a higher level of risk. Their prices can swing dramatically over time, and in worst-case scenarios, you could lose a significant portion of your investment if the company goes bust.

Bonds, on the other hand, are more predictable. They’re seen as safe havens for conservative investors because of the steady interest payments and return of principal. However, this safety comes at a cost—bonds don’t usually provide the same high returns that stocks can. If you’re looking for slow and steady growth with minimal risk, bonds might be your go-to.

In a nutshell, stocks are for growth, while bonds are for stability. You’ll typically want to hold a mix of both, depending on your financial goals and how much risk you’re comfortable with.

If you’re new to the world of stocks, you might be wondering how buying and selling shares works. For a complete guide, check out our introductory article on stock trading to get a solid foundation on how stock markets operate and how investors profit.

Why Do Companies Issue Both Stocks and Bonds, But Governments Only Issue Bonds?

When it comes to raising money, companies and governments have different strategies. While companies can issue both stocks and bonds, governments typically only issue bonds. But why is that? Let’s break it down.

Governments and Bonds: Borrowing to Fund Public Spending

Governments issue bonds as a way to borrow money. These funds help finance things like infrastructure projects (think roads and bridges), healthcare, education, and other public services. By issuing bonds, a government can collect money from investors, promising to pay them back with interest over time. In return, investors get a relatively safe, low-risk investment, especially if they’re lending to a stable government.

But why don’t governments issue stocks? Well, the answer is simple: governments aren’t companies. They don’t have ownership to offer in exchange for investment. Stocks represent ownership in a company, and since governments don’t operate like businesses with shareholders, there’s no ownership to sell.

Governments also don’t aim to generate profits like companies do. Instead, they manage public resources and provide services. Therefore, borrowing through bonds makes more sense. They can raise the money they need without having to give investors a stake in the country’s “ownership”—which would be quite difficult to do, since the government serves its citizens, not shareholders!

Companies: Using Both Stocks and Bonds to Raise Capital

Companies, on the other hand, have a choice. They can raise money by issuing both stocks (equity) and bonds (debt). Each method has its advantages and disadvantages, depending on the company’s goals and financial strategy.

1. Stocks: When a company issues stock, it’s selling ownership in the company. This means anyone who buys shares becomes a partial owner, with the potential to benefit from the company’s success. For the company, selling stock is a way to bring in money without creating debt. However, issuing stock also means that the company’s original owners (like the founders) will have less control over decision-making because they’re sharing ownership with others. The downside for the company is that issuing too much stock can dilute ownership. For example, if you own 50% of a company, but it issues more shares to new investors, your ownership stake might shrink, reducing your say in company decisions and your share of the profits. Despite this, stocks can be a great way for companies to raise large amounts of money, especially if they are planning to expand.
2. Bonds: When a company issues bonds, it’s borrowing money from investors without giving up any ownership. Investors lend the company money in exchange for regular interest payments, and the company agrees to pay back the principal at the end of the bond’s term (when the bond “matures”). Bonds are especially useful for companies that don’t want to dilute their ownership or lose control but still need to finance their growth. The downside to issuing bonds is that the company takes on debt. This means it must pay back the loan plus interest, regardless of how well the company performs. Too much debt can be risky, especially if the company struggles to make enough profit to cover its interest payments. On the flip side, bonds allow the company to raise money without giving up ownership, making it an attractive option for many businesses.

Balancing Debt and Equity: Why Companies Use Both

Many companies use a combination of stocks and bonds to raise money. Why? Because each option serves a different purpose, and using both helps create balance.

• Stocks allow companies to raise large amounts of money without the pressure of having to repay a loan. However, issuing too many shares can dilute ownership and control.
• Bonds provide a way for companies to borrow money without giving up any ownership, but they come with the obligation to repay the debt with interest.

By issuing both, companies can spread their risk. For example, they might sell stocks to finance long-term growth (like launching a new product or expanding into new markets) and use bonds to cover shorter-term needs (like buying new equipment or refinancing existing debt).

Essentially, companies aim to strike a balance between debt and equity. Too much debt can make them vulnerable if business slows down and they can’t meet their repayment obligations. But too much equity can dilute their control over the company. That’s why they carefully choose when and how much to issue of each.

Why Don’t Governments Issue Stocks?

As mentioned earlier, governments aren’t like companies. They don’t have ownership shares to offer because they don’t operate for profit, nor do they have shareholders. Their goal is to manage resources and provide public services, not to make money for investors.

Bonds make more sense for governments because they need to raise money for public spending—whether it’s building a new highway, funding schools, or supporting healthcare. By issuing bonds, they can borrow from investors without giving up any control. In return, investors get a low-risk opportunity to earn steady interest payments.

Basically, companies use both stocks and bonds because it gives them flexibility in how they raise money. Bonds let them borrow without giving up ownership, and stocks let them raise capital without taking on debt. Governments, however, stick to bonds because they aren’t selling ownership—they’re borrowing to finance the nation’s needs.

Risk and Return: Stocks vs Bonds Over the Last 30 Years

When we talk about investing, one of the most important things to consider is how risk and return play out over time. Stocks and bonds each have their own unique balance of risk and reward, and understanding how they’ve performed over the last 30 years can give us a good idea of what to expect going forward.

Stocks: High Returns, High Risk

Over the past 30 years, stocks have generally delivered higher returns compared to bonds, but with significantly more ups and downs. If you had invested in the S&P 500 (an index representing 500 of the largest US companies), your average annual return would have been around 10%. That’s a strong return, but it didn’t come without some turbulence.

From the late 1990s through the early 2000s, the stock market experienced some dramatic moments, like the dot-com bubble. Many tech stocks skyrocketed in value, only to come crashing down when the bubble burst. Then came the Great Financial Crisis of 2008, when stock markets worldwide saw huge losses as financial systems nearly collapsed. Despite these crashes, the stock market recovered and continued to grow.

For those looking at growth sectors, cybersecurity stocks offer exciting opportunities. As technology advances, protecting digital assets has become crucial. Explore our article on top cybersecurity stocks for insight into companies leading in this space.

This rollercoaster effect is what we call volatility. Stock prices can swing wildly up or down, and while the long-term trend is usually upward, you have to be prepared for the ride. Stocks are generally seen as high-risk, high-reward investments. In good times, you can see your investment grow rapidly, but in bad times, you could lose a significant portion of your money if you sell during a downturn.

According to A Wealth of Common Sense, “Stocks were up 80% of the time over the past 30 years.” This means that despite the crashes, stocks were more likely to go up than down during most of this period.

Bonds: Lower Returns, Lower Risk

In contrast, bonds have been much steadier. Over the last 30 years, bonds delivered an average return of around 4-6% per year. While this is lower than what stocks have typically offered, bonds are known for being safer investments. They don’t have the same wild price swings as stocks, making them less risky.

Bonds are often seen as a safe haven during periods of market turmoil. For example, when the stock market tanked during the Great Financial Crisis, bonds—particularly government bonds—held their value better and continued to provide steady interest payments to investors. However, bonds are not completely without risk. If interest rates rise, the value of existing bonds can fall, but this tends to be a much more gradual and predictable process compared to the volatility of stocks.

Again, from the same source, A Wealth of Common Sense notes that “Bonds were up 80% of the time as well,” showing that while bonds may not provide the same spectacular returns as stocks, they are still reliable over the long haul.

Inverse Performance: Stocks and Bonds Working Together

One key concept to understand when comparing stocks and bonds is the idea of inverse performance. In simple terms, when stock prices are falling, bond prices often rise, and vice versa. This happens because investors tend to move their money into safer assets like bonds when the stock market becomes too risky. Conversely, when the stock market is booming, fewer people want bonds, so their prices can drop.

For example, during the dot-com bubble and the 2008 financial crisis, many investors flocked to bonds as stocks plummeted. Bond prices rose, helping those who had invested in them avoid the worst of the downturn. This inverse relationship can make bonds a good way to balance the risk in a portfolio. If stocks are performing poorly, bonds can help stabilise things by providing steady, reliable returns.

However, this relationship isn’t always perfect. In rare instances, like during 2022, both stocks and bonds performed poorly due to rising interest rates and inflation concerns. This shows that while bonds and stocks often move in opposite directions, they can both be affected by broader economic factors, such as inflation or central bank policies.

Major Financial Events: Learning from History

Over the last 30 years, several major financial events have influenced the performance of both stocks and bonds. Here’s a quick overview of some of the most significant:

1. The Dot-Com Bubble (1999-2001): The rapid rise and fall of technology stocks in the late 1990s led to huge losses in the stock market. Many investors who had poured money into tech companies saw their investments lose value almost overnight. Bonds, however, held steady during this period, providing some relief to those who had diversified their portfolios.
2. The Great Financial Crisis (2007-2009): One of the most severe economic downturns in modern history, the financial crisis caused stock markets to plunge by more than 50% in some cases. Bonds, particularly government bonds, fared much better, as they were seen as safe assets during the chaos. This event highlighted the importance of having a mix of stocks and bonds in your portfolio.
3. The COVID-19 Pandemic (2020): The early months of the pandemic saw stock markets crash as economies around the world shut down. However, stocks quickly rebounded, and many ended up reaching new highs within the year. Bonds also played a stabilising role during the initial market panic, providing investors with a less volatile option amid the uncertainty.
4. The 2022 Market Decline: This was an unusual year where both stocks and bonds faced declines. Rising interest rates aimed at curbing inflation led to drops in bond prices, while stocks also struggled due to fears of a slowing economy. It was a tough year for both markets, underscoring the importance of long-term thinking in investing.

Stocks and Bonds: Complementing Each Other

In the end, stocks and bonds play different but complementary roles in a well-balanced portfolio. Stocks offer the potential for high returns but come with higher risk and volatility. Bonds, on the other hand, provide stability and lower risk but tend to deliver smaller returns.

By investing in both, you can spread out your risk. When stocks are doing well, your portfolio grows. When stocks take a dip, your bonds can help cushion the fall by providing steady interest income and retaining their value. This balance between risk and stability is why most financial experts recommend holding a mix of both stocks and bonds, especially as you get closer to retirement.

In essence, history shows that both stocks and bonds can perform well over the long term, but they do so in very different ways. Knowing how to balance them in your portfolio can help you achieve both growth and security in your financial journey.

How Are Stocks and Bonds Taxed Differently?

When it comes to investing, it’s not just about how much you can make—it’s also about how much you get to keep after taxes. Stocks and bonds are taxed in very different ways, and knowing how this works can help you make smarter choices about where to invest your money.

Taxes on Bonds: Interest as Income

When you invest in bonds, the income you receive comes in the form of interest payments. These payments are considered regular income, just like the salary you earn from a job, and they are usually taxed at your ordinary income tax rate. This means the more money you make overall, the more you’ll pay in taxes on your bond income.

For example, let’s say you earn £500 in interest from a bond investment. If you’re in a 20% tax bracket, you’ll owe £100 in taxes on that income. It’s pretty straightforward—just like being paid for work, your bond interest is taxed as regular income.

As NerdWallet explains, “Bond payments are usually subject to income tax, while profits from selling stocks are subject to capital gains tax.”

There are some bonds, like municipal bonds (usually issued by local governments), that can be tax-exempt at the federal level, meaning you might not have to pay taxes on the interest they earn. In some cases, these bonds are also exempt from state taxes if you live in the state where the bond was issued. This makes them an attractive option for investors looking to minimise taxes, especially those in higher tax brackets. However, tax-free bonds typically offer lower interest rates to balance out this advantage.

Tax efficiency is a key part of building wealth and moving toward financial independence. Learn more about how to plan for your future in our article on understanding financial freedom, where we discuss ways to achieve long-term financial goals

Bonds may also face a different kind of tax treatment if you sell them before maturity for a profit. In that case, the profit you make from selling the bond at a higher price than you paid is subject to capital gains tax, which we’ll explain further in the section on stocks.

Taxes on Stocks: Capital Gains and Dividends

When you make money from stocks, it typically comes in two forms: capital gains and dividends. Both are taxed differently than bond interest.

• Capital Gains: This is the profit you make from selling a stock for more than you paid for it. For instance, if you buy shares for £1,000 and later sell them for £1,500, that £500 profit is your capital gain. Unlike bond interest, capital gains aren’t taxed as regular income. Instead, they are subject to capital gains tax, which can be lower than your income tax rate, depending on how long you held the stock. If you’ve held the stock for less than a year, the profit is considered a short-term capital gain and taxed at your ordinary income tax rate (just like bond interest). But if you’ve held the stock for more than a year, you qualify for long-term capital gains tax, which is typically lower. This can be a big advantage for long-term investors who want to reduce their tax burden.
• Dividends: Some stocks pay out dividends, which are regular payments companies make to their shareholders from their profits. Dividends are usually taxed as qualified dividends, which often receive favourable tax rates. Like long-term capital gains, these qualified dividends can be taxed at a lower rate than regular income, making dividend-paying stocks a tax-efficient way to earn money.

However, not all dividends qualify for the lower tax rate. Non-qualified dividends (sometimes called ordinary dividends) are taxed at your ordinary income tax rate, just like bond interest.

Special Tax Considerations for Bonds

While bond interest is typically taxed as income, there are some important exceptions and benefits that certain bonds can offer. For instance:

• Municipal Bonds: As mentioned earlier, interest from municipal bonds is generally tax-exempt at the federal level and sometimes even at the state and local levels. This makes them particularly appealing for high-income investors, as they provide a way to earn tax-free income. However, these bonds tend to offer lower interest rates compared to taxable bonds, so it’s a trade-off between lower taxes and lower returns.
• Treasury Bonds: US Treasury bonds are another type of bond with special tax treatment. While the interest earned from Treasury bonds is exempt from state and local taxes, it is still subject to federal taxes. This can be beneficial for investors living in states with high income taxes, as it reduces the overall tax burden on the bond’s interest.
• Capital Gains on Bonds: If you decide to sell a bond before it matures, any profit you make will be considered a capital gain and taxed accordingly. This works similarly to stocks—if you’ve held the bond for less than a year, the gain is taxed at your ordinary income rate (short-term capital gains). If you’ve held the bond for more than a year, it qualifies for the lower long-term capital gains tax rate.

Understanding these different tax treatments is crucial when deciding between stocks and bonds. You might prefer bonds for their stability and reliable income, but remember that their interest is taxed as regular income. On the other hand, stocks may offer more tax-efficient growth, especially if you hold them long enough to benefit from the lower long-term capital gains rates.

Choosing Between Stocks and Bonds: Tax Considerations

When you’re building an investment portfolio, taxes are an important factor to consider. Stocks can be more tax-efficient over the long term, especially if you hold onto them for more than a year to qualify for lower capital gains tax rates. Stocks that pay qualified dividends can also offer tax advantages.

Bonds, while providing steady income, can lead to a higher tax bill because their interest is taxed as regular income. However, if you invest in tax-exempt bonds, like municipal bonds, you can avoid paying taxes on the interest altogether, making them a smart option for investors in higher tax brackets.

Balancing Stocks and Bonds in Your Portfolio

When it comes to building a smart investment portfolio, it’s not just about choosing between stocks or bonds—it’s about finding the right mix of both. By combining these two types of investments, you can create a more balanced approach that taps into the growth potential of stocks while benefiting from the stability of bonds. This blend helps you manage risk while still aiming for good returns over time.

As NerdWallet explains, “A portfolio containing a mix of stocks and bonds is more diversified and potentially safer than an all-stock portfolio.”

Why Diversification is Key: Balancing Risk and Reward

One of the key reasons to hold both stocks and bonds is diversification. In simple terms, diversification means spreading your investments across different assets so that you’re not putting all your eggs in one basket. If one part of your portfolio (like stocks) performs poorly, the other part (like bonds) might hold steady or even perform well, helping to reduce overall risk.

• Stocks: As we’ve discussed, stocks offer higher potential returns over time because you’re buying ownership in a company. If the company does well, your shares increase in value, and you may also earn dividends. However, stocks are also more volatile—their value can rise and fall quickly, which means there’s more risk involved.
• Bonds: Bonds, on the other hand, provide a steady stream of income through interest payments. While the returns are generally lower compared to stocks, bonds are much more stable and can act as a cushion during turbulent market times. This stability helps to protect your portfolio when stock prices are fluctuating wildly.

By owning a combination of both, you can capture the growth potential of stocks while relying on bonds to stabilise your portfolio, especially during market downturns. When stock prices fall, bonds tend to hold their value (and sometimes even rise), helping to offset losses. This mix of growth and safety is what makes a balanced portfolio more resilient over the long term.

Determining how much of your portfolio should be allocated to stocks can be tricky. If you’re unsure about how much to invest in stocks, check out our guide on how much to invest in the stock market, which walks through strategies based on risk tolerance and financial goals.

Age-Based Allocation: How Much to Invest in Stocks vs Bonds

One common strategy for figuring out how much of your portfolio should be in stocks versus bonds is the “100 minus your age” rule. The idea is simple: subtract your age from 100, and that’s the percentage of your portfolio you should invest in stocks, with the remaining amount in bonds.

For example:

• If you’re 30 years old, you might invest 70% in stocks (100 – 30) and 30% in bonds.
• If you’re 60 years old, you would invest 40% in stocks and 60% in bonds.

The reasoning behind this strategy is that younger investors can afford to take on more risk (with stocks) because they have a longer time horizon to recover from any market downturns. As you get older and approach retirement, stability becomes more important than growth, so you would shift more of your investments into bonds to protect your nest egg.

However, some financial experts suggest using a more modern version of this formula, such as “110 minus your age” or even “120 minus your age”. This approach accounts for longer life expectancies and the fact that stocks have historically delivered better long-term returns than bonds. By using a higher number, you would invest a bit more in stocks to take advantage of their growth potential, even as you get older.

For example:

• If you’re 40 years old using the “110 minus your age” strategy, you would invest 70% in stocks and 30% in bonds, slightly more aggressive than the original “100 minus your age” rule.

Finding the Right Balance for You

While these age-based strategies are a useful guideline, the right balance between stocks and bonds depends on your personal risk tolerance and financial goals. Some people feel comfortable taking more risk because they’re confident in the stock market’s long-term growth potential. Others prefer a safer, more predictable return, even if it means potentially earning less over time.

In general, if you’re someone who can handle the ups and downs of the stock market without panicking and selling during downturns, you might choose to have more of your portfolio in stocks. On the other hand, if you’re risk-averse or nearing retirement, you might prefer to have a higher percentage of bonds, which offer more security and predictable income.

A well-balanced portfolio will help you navigate market volatility and reach your financial goals, whether you’re planning for retirement, a big purchase, or just long-term wealth-building. And as your goals or circumstances change, so too can your mix of stocks and bonds.

Rebalancing Your Portfolio

Over time, the value of your stocks and bonds will change as the market fluctuates, which could throw your portfolio off balance. For example, if your stocks grow much faster than your bonds, you might end up with too much risk compared to what you originally planned. That’s where rebalancing comes in.

Rebalancing means adjusting the amounts of stocks and bonds in your portfolio to bring them back in line with your original plan. You might need to sell some stocks to buy more bonds, or vice versa, to restore your desired balance. This is an essential part of managing risk and keeping your portfolio on track.

Final Thoughts: The Power of a Balanced Portfolio

A portfolio that includes both stocks and bonds can offer the best of both worlds—growth potential from stocks and stability from bonds. By diversifying, you reduce your overall risk and make your investments more resilient to market swings. And by following strategies like the “100 minus your age” rule, you can adjust your stock-bond mix as you move through different stages of life.

Ultimately, finding the right balance between stocks and bonds is key to reaching your long-term financial goals while managing risk along the way. It’s a strategy that helps ensure your portfolio can grow over time, while also providing a safety net for when markets get rocky.

So, Elephants, remember: balancing your portfolio is not just about maximising returns but also about making sure you can sleep well at night, knowing your investments are working for you in the most efficient way possible.