Those that have money in stock, bonds or both often find themselves at a loss when asked what the difference is between the two. They may have a vague idea that bonds are safer and have a lower return (which is generally true) and a confused idea that when one of them is up the other is down but beyond that the average investor is at a loss.
The definitions are surprisingly simple and straightforward as are the explanations of why they react as though they were at opposite ends of a see-saw.
Stocks – When you buy stock you are actually becoming a part owner of the company. If you buy enough stock you can even have a real say in how the company is run. When the company does well the price of its stock goes up and you can make a profit if you sell your shares. In addition when the company does well it may pay dividends. Dividends are profits that the company returns to its investors (owners). When the company does not do well its stock will go down and if you sell at this time you may take a loss depending on the price of the stock when you bought yours. Of course if you hold onto your stock there is the likelihood that it will once again go up in value.
Bonds – A bond is a loan to a company and pays regular interest payments for the life of the bond. Once the bond becomes due the face value of the bond is paid back. Bonds don’t have the earning potential of stocks but are safer because the interest rate and term of the bond are set and even if a company does badly and its stock falls the terms of the bond still apply. A bond can’t be cashed in before it matures but can be sold to someone else.
The so called see-saw effect describes the interplay between the stock market and bond market prices. When the stock market is rising and its growing ability is greatest bonds sell for lower prices. If, for instance, you held a $10,000 bond that paid 4% interest and would not mature for 20 years you might be eager to sell the bond and invest in the soaring stock market but you would have to give an incentive to persuade anyone to buy your bond. In such a case you might have to sell the bond for only $9,000. The new owner would pay the $9,000, receive the interest every year and when the bond matures collect $10,000. When the stock market is not doing well and investors are looking for a safe place to put their money they may be willing to pay more then the face value of a bond.
Another advantage of bonds over stocks is that if a company goes into bankruptcy and its assets are liquidated the resulting cash is used first to pay debtors and the remaining cash is divided among the investors (stockholders). So those holding bonds are more likely to receive payment then those owning stocks.
This is a simplified explanation of stocks and bonds but understanding must start with the simple and work its way through to the complex. Hopefully, this article has given you a firm foundation upon which to build.