Photo by Ishant Mishra
Stocks and bonds are night and day. Both provide a path to profit if you have the right investment strategy or a path to lose everything if you don’t.
Understanding the differences between stocks and bonds can help you make better choices when diversifying your portfolio. Here is an overview of how stocks and bonds differ.
What is a Bond?
Do you ever wonder how banks make money? Well, one of the top ways is through issuing loans.
When a bank loans money to a person or business, they are repaid the loan amount plus interest. This interest can mean big profits on large amounts.
Bonds are a type of loan you can buy. You make money on interest, or a premium, that accrues on the debt as if you were a bank.
With bonds, the borrower is a company that agrees to repay you the amount of the debt plus a premium known as a coupon. At the end of the lending term, or when the bond matures, you receive the bond’s face value.
Your goal as an investor is to buy bonds that have solid return potential. The terminology might seem tricky at first, but here are a few key terms to look out for when choosing bonds.
A bond’s maturity date tells you when the principal amount will be repaid. This is also the date the company, or borrower is no longer obligated to make interest payments.
A maturity date is important because it defines the lifetime of the bond. When choosing a bond, knowing the maturity date can help you decide whether you’ll receive a high enough return on your investment.
Short term bonds typically last between one and three years. Medium to long term bonds last for at least ten years.
Secured or Unsecured
A secured bond offers more security to investors than unsecured bonds. If the company can’t pay its investors back, bondholders receive collateral instead to make up for the loss.
Unsecured bonds don’t offer any form of collateral. If the company fails or can’t repay its debt, you lose your investment.
These bonds, also called debentures, are popular with investors who know the creditworthiness of the borrower and feel confident in its ability to repay the debt.
One of the major differences between stocks and bonds is liquidation preference. When a company goes bankrupt, debt gets repaid first.
Senior debt gets paid back first followed by junior debt. Stockholders are repaid last.
One major consideration when choosing a bond is its coupon amount. The coupon amount is the amount of interest you’ll receive until the bond matures.
The coupon amount is paid either annually or semiannually. You can calculate the coupon rate by dividing the annual payments by the face value of the bond.
What are Stocks?
Want to become part owner in a billion-dollar business? When you buy stocks, that’s exactly what you’re doing.
Depending on the profile of the business you’re purchasing, you could become a shareholder in a multinational corporation earning trillions of dollars per year. But you’re not alone.
Public companies sell stocks to millions of other individuals and investment groups. Unless you’re planning to invest millions, your percentage of ownership usually won’t earn you a seat on the board of directors.
Owning stock is beneficial because when a company’s profits go up, the value of the stock typically follows suit. You can choose to buy or sell stock at any time.
The amount you earn is based on the price of the stock shares when you sell. If you sell stocks for less than you bought them, you lose money.
If you sell stocks for more than you bought them, you earn money. It’s almost impossible to predict the direction of the stock market on any given day.
This makes stocks a risky investment when investing for the short term. If you’re looking for a sure bet, the key is to diversify the types of stock you own and choose companies with a proven track record of success.
You can research companies online using companies like Morningstar or Market Watch to decide whether or not a company is a good investment.
How Do Stocks and Bonds Differ?
One of the biggest differences between stocks and bonds is certainty. With bonds, you have an opportunity to choose investments that come with a guaranteed return.
For example, secured federal government bonds are a sure bet because you know the amount you need to pay and how long it will take to earn a certain amount of profit. But when investing in the stock market, you have no idea what will happen day-to-day.
You can’t time the stock market because you don’t know how news outlets, internal staff changes or product changes will affect the stock’s price short term. But stocks have a much better track record of success when it comes to turning a profit.
Since 1926, top-performing companies return an average of 10 percent to investors. With bonds, the average rate of return is only 5 percent.
In the long term, you do have a stronger chance of success if you buy into a fund that includes a mix of conservative stocks.
Navigating Differences Between Stocks and Bonds
Are bonds are better than stocks? That depends on your risk tolerance and investment strategy.
Buying individual stocks is risky business unless you are an experienced investor. Most financial experts recommend that beginners invest in a mutual fund or index fund that gives them access to a wide range of top-performing companies.
Though you still might lose money when the market crashes, most conservative funds will increase in value over the long term. With bonds, you sign up for what you want in advance.
Your profits are fixed which has its pros and cons. The biggest disadvantage is that there’s a cap on how much you earn in profit.
The advantage is that you know you’ll be repaid if the bond is secured. For more financial information and tips, check our blog for updates.