Understanding the Difference Between Stocks and Bonds

The moment my fingers met the keyboard to begin this article, I had a lucid dream flashback to a Broadway Playbill with a song called Stocks & Bonds. Now, for the life of me, I can’t remember which musical this came from or why I seem to have repressed the memory. DM me if you know what’s going on in my subconscious right now.

Anyway, let’s talk about stocks and bonds, arguably one of the most boring topics I could possibly address with you but one that forms the basis for a lot of decisions you’ll probably need to make in your financial life if you decide you want to become filthy stinkin’ rich.

The good news is you don’t really need to understand much beyond the basics to be an investor in 2020. In fact, you technically wouldn’t need to understand anything, especially when you use a service like Betterment – but I’d argue that it’s good to know (even if it’s just a little) what’s happening in your Vanguard 2060 target date fund.

Stocks

Every time you buy a stock (or, more likely, an index fund that’s composed of many different stocks), you’re buying a tiny little share of a company. Which means when they make money, so do you! Woohoo!

The bad news? When they lose money, stockholders usually bear the brunt. In short, they’re volatile.

But because there’s no cap (theoretically speaking), there’s really no limit to how much you could make. The downside, of course, is that you can lose every last penny.

For example, if you bought 10 shares of TSLA at $42.10 in 2017 for $421.00, today you’d have $3,727.20. That’s about a 780% return.

For a less titillating example, maybe instead of TSLA you had purchased a single share of CHKAQ (Chesapeake Energy) for a whopping $1,404 in 2017. Today, that single share would be worth $5.30.

These are both real examples that illustrate some of the most #dramatic moves I could think of.

You can think of purchasing a stock a little bit like gambling. But instead of putting all your chips on red or black, you’re putting chips on one, specific hue of one color on a massive color wheel that moves unpredictably. [This is why I’m a huge fan of low-cost index funds – I’m not a betting woman, but I have enough faith in the entire stock market to go up over time – so instead of buying Cornflower or Cerulean, you’re buying an entire row of all blue, or a little bit of the entire rainbow. Is this color wheel example working for me?]

So at its most granular level, a stock is a single share of a single company. When we refer to “stocks” within a portfolio more casually, we’re usually referencing entire collections of them, like VTI (Vanguard Total Stock Market Index Fund), which tracks all the stocks in the entire U.S. stock market.

For example, almost my entire Roth IRA is invested in VTSAX, or “Vanguard Total Stock Market Index Fund Admiral Shares” – this is an index fund.

VTI, mentioned above, is the ETF version of VTSAX. The only real difference between an index fund and an ETF is that an ETF can be traded throughout the day, as if it were a single stock.

As of the end of August 2020, the top 10 holdings (making up 23% of the fund’s value) in VTSAX were:

Apple Inc.

Microsoft Corp.

Amazon.com Inc.

Alphabet Inc.

Facebook Inc.

Johnson & Johnson

Berkshire Hathaway Inc.

Procter & Gamble Co.

Visa Inc.

UnitedHealth Group Inc.

So indirectly, I do own some Apple. And some Alphabet. And some Amazon. Because I bought tens of thousands of dollars of VTSAX, which fund managers at Vanguard stuffed with companies they deem promising.

The stocks in your portfolio are responsible for its growth. They’re also usually responsible for downswings. Most of the time, a young person should have 90%+ stocks in their long-term investment portfolios – the higher the percentage, the more risk you’re inviting in. But that’s the beauty of starting early, baby! When you’re young, you’ve got decades to weather the storm.

Bonds

So here’s the funky thing about bonds: While a stock can only be purchased in a publicly traded company, you can buy bonds from companies or governments. You’re essentially buying a loan that the company or government has to repay you in the future, with interest.

The return on a bond is capped – which means, unlike TSLA, you’re not going to get a 780% return over three years. Whether a company does extremely well or not, there’s a much greater chance that you’re going to end up with the amount you agreed upon upfront.

Bonds provide stability in an investment portfolio – you can think about them a little like your trusty pair of joggers in the closet. You’re probably not going to turn many heads or get asked out on a date in your old faithful pair of athleisure pants, but you’re also not going to spectacularly embarrass yourself. Reliability! Consistency! #bonds

(I told you this subject was boring – I am reaching here, people.)

If you’re interested in learning a more salacious take on bonds, pick up the book or stream the movie The Big Short. It reveals the unwieldy underpinnings of the financial crisis in 2008 and, while it’s tremendously confusing at points, part of the irony of the story is that most of the bond managers in fixed income departments on Wall Street also didn’t understand what they were buying and selling – in short (BIG short), bond managers packaged tranches of subprime mortgage loans together in bonds, then sold them off with faulty ratings.

They got enormously wealthy, then people defaulted on their subprime mortgages. The bonds went bad. The system collapsed. Everyone lost their job – except for a handful of people who saw it coming and shorted the subprime mortgage bonds by doing this wonky, backwards thing called a “credit default swap.”

Again, it’s convoluted – but both the movie and book are excellent, and they may help illustrate why you see language like, “Bonds are usually more reliable.” Nothing is a certainty when you invest, but bonds are about the closest thing we’ve got.

What you really need to know

All you functionally need to know is that when you look at your holdings in a portfolio (be it a target date fund for retirement, a General Investing account with Betterment or Ellevest, or a portfolio you’re courageously assembling yourself), you want to have a balance that skews heavy on the stocks and light on the bonds if you’re planning on using the investment in, say, 30 years – but you’ll want to temper that enthusiasm for #risk if you intend to access the money in the shorter term.

That being said, if you’re going the ETF route (like investing in VTI; in other words, the entire stock market), you’re doing a pretty good job of mitigating risk to begin with.