Stocks and bonds are both powerful investment tools with great earning potential. Though you may hear these terms used together often, they are not the same thing. A stock is very different from a bond. You need to understand how these options work so you can make the right choices for your investment portfolio.
- Both stocks and bonds are readily available for a variety of companies, and many companies provide both.
- Stocks are a higher-risk option with greater earning potential.
- Bonds a generally lower risk with stable earning potential that’s not as promising as some stocks.
- A well-rounded investment portfolio should have a combination of stocks and bonds.
Why You Need to Know the Difference Between Stocks and Bonds
Businesses should issue both stocks and bonds to maintain a strong capital structure. This gives investors two distinct options to choose from when supporting an organization. While both picks are beneficial to the business, there are some important differences in how they’re issued and what their investment potential is. It’s important to understand the difference between stocks and bonds so you can make a well-informed decision for your portfolio.
It’s also important to explore conversion features for your investments. Some bonds allow bondholders to convert them to company stock at particular ratios. If you know what to look for, you can make wise decisions that allow you to use this option to its fullest potential and enjoy an immediate capital gain.
What Are Stocks?
Stocks are sold in shares with each share representing a fraction of ownership in the company. For example, if a company sold 10,000 shares and you purchased 1,000 of these, you would own 10% of that business’s assets. Companies issue stocks to raise capital for their operations. Investors select stocks in companies they believe will be profitable. As a stockholder, you have a claim to the company’s assets. When the company’s value increases, so too does the value of the stock.
What Are Bonds?
Bonds are fixed-income investments issued when a company needs a loan to finance its growth. When a company issues a bond, it issues a debt to the bondholder. The bondholder then receives regular interest payments over the life of the loan and a full repayment when the bond matures. In some cases, a bond may default because the company is unable to repay the debt. If this happens, the bondholder loses their investment.
Rating agencies like Moody’s and Standard & Poor’s rate bonds based on the likelihood of defaulting. Those with a higher rating are safer investments that are unlikely to default. Lower ratings indicate high-risk choices with a good chance of defaulting.
Differences Between Stocks and Bonds
There are many key elements that cause a stock to differ from a bond. Consider the notable differentiation in the following areas.
Stocks may or may not issue dividends. A dividend is a periodic interest payment to the shareholder. A bond, however, nearly always issues interest payments. In rare cases, a bond may include the option for the issuer to cancel or delay an interest payment.
Shareholders that don’t get dividends only make money with stock trading if they choose to sell their stocks. A bondholder may elect to sell the bond before it matures to receive their payment sooner, but they are guaranteed repayment upon maturity as long as the bond doesn’t default. Once the bond has matured, you no longer own this investment.
Priority of Payments
If a business is liquidated, bondholders take higher priority than holders of stock. The terms of the bond will determine exactly when it’s repaid. Shareholders always have the last claim to residual cash and may receive nothing. Preferred stock shareholders take priority over common stock shareholders.
If you hold common stock in a company, you have voting rights that give you a say in how the business operates. You will typically have the opportunity to vote on issues such as stock splits, corporate policies, and who is on the board of directors. Bondholders and preferred stockholders don’t have this right.
Length of Investment
Bonds have a set term after which they mature and they’re repaid. Stocks do not have this feature.
A stock is generally riskier than a bond. Bonds are fixed-income securities with regular interest payments and a maturity date. If the company doesn’t default, the buyer is guaranteed a return on the investment. Stocks don’t always pay dividends and the value can rise and fall unpredictably. Investors must perform thorough research into a company to determine the investment potential for any stock. The payoff for a bond is established at the time of purchase. In this case, the investor need only evaluate the company for the likelihood that it will default on the bond payments.
Though stocks carry more risk, they also offer greater income potential. As mentioned previously, there is a set repayment schedule for a bond. Bondholders know the maximum earning potential from this purchase. A stockholder doesn’t know the earning potential for their purchase. Stocks may offer an incredible payoff for those who make the right investment choices.
Since 1929, bonds have offered average earnings of 6% per year while stocks provide average earnings of 10%. It’s important to note however that these averages are not guaranteed. A stock may easily over- or underperform.
Similarities Between Stocks and Bonds
Though stocks and bonds are very different, there are a few similarities worth noting between the two.
You can trade both stocks and bonds on a public exchange. Large publicly-held companies will often list their stocks and bonds this way. Smaller companies are more likely to sell their stocks and bonds over the counter (OTC). OTC trades occur directly between brokers and dealers through a decentralized network. This is preferable for startups that can’t afford the cost of listing on a major exchange. Those that don’t meet the stringent requirements for a public exchange can also default to trading OTC.
Though it’s possible to find stocks and bonds in both places, it’s more likely for stocks to list on public exchanges while bonds are more commonly sold OTC.
Interest Rate Sensitivity
Stocks and bonds are both sensitive to changes in interest rates. As interest rates increase, the price of stocks and bonds will fall as future cash flow declines with high rates. As interest rates fall, prices will climb.
Stocks and bonds are both readily available, and many companies offer both options. This means that investors should have no trouble finding the type of investment that they’re looking for within their preferred industry. These are common securities that you can find in numerous variations, making them an easy choice for a quick investment opportunity.
Investment Through Funds
You can invest in both stocks and bonds through funds. A fund for stocks allows you to purchase shares in several stocks through a single fund. Stocks are primarily available through:
- Mutual funds: Portfolios of stocks that regularly change.
- Exchange traded funds (ETFs): Investments in stock market indices where stocks only change if the index is reconfigured
Bonds are available through funds that divide ownership of the bond among several individuals. When bonds are issued, there’s often a minimum purchase requirement, such as 10 bonds per purchase. This can make some bonds too expensive for smaller investors. A bond fund allows you to invest in less than the minimum number of bonds for a particular company. A bond fund may contain several bonds from different companies for diversification.
How to Choose Between Stocks and Bonds
Understanding the differences between stocks and bonds can help you decide what to purchase when. You shouldn’t make a blanket choice between either stocks or bonds, though. A strong investment portfolio nearly always includes a blend of stocks and bonds. Bonds offer greater stability that can carry you through a downturn in the stock market, while stocks provide greater earning potential. Select a combination of the two for the greatest chance of financial success.
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