Last Updated: January 11, 2023
Have you already diversified your investments, or are you planning to? In both cases, learning the difference between stocks and bonds can be a deciding factor. In the ever-evolving world of economics, it is worth doing your share of research, even if you have an army of trustworthy agents by your side. Knowledge is always your best tool and your safest backup!
While stocks may sound more familiar to a beginner market investor and, therefore, seem like a safer option, investing in bonds can be significantly more lucrative in some cases. If you want to learn how to place yourself correctly in this system and weigh your financial decisions, stay with us. This article will help you learn more about stocks and bonds respectively, their main differences, and the present risks.
What Are Stocks?
Stocks are the percentage of shares in a company or corporation that one holds or can lay a claim on. Basically, when you buy stocks, you’re buying a part of a company. Buying 5% of company shares will make you a 5% owner and affect your further investment to that extent. Even fewer shares would make you a partial owner and give you some of the owner’s rights. Of course, the bigger the share percentage the greater your rights as the partial owner. That is why another common term for stocks is equities. That works the same for large corporations or newly established companies.
However, as a stockholder, you are greatly dependent on the company’s success and the market trends. Trading stocks and bonds is risky and requires a lot of effort and involvement; however, it’s also very rewarding and potentially lucrative.
What Are Bonds?
Bonds put you in a different type of relationship with a governmental or business entity than stocks. However, they can be equally or even more profitable.
While they may seem similar, the way bonds market functions is completely different from the stock market. Bonds are loans that you give to a corporation or, in some cases, the government that they pay off with interest. So, a bond yield is mainly based on these interest rates. As a bond owner, you don’t own a part of the corporation; instead, the corporation is in debt with you.
Upon the bond maturity, the corporation, government, or other in-debt-entity is obliged to return the full principal to the investor. In the meantime, it has to pay out interest in predetermined installments as well.
But maybe your understanding of the difference between stocks and bonds will be better if we take time and make some comparisons.
So, What Is the Difference Between Stocks and Bonds?
Stocks and bonds have numerous differences. Starting with your initial investments, your responsibilities as an investor, and, finally, revenues, not to mention the various kinds of risks involved. Still, the fundamental difference is in the way that these two investment options work.
The difference in how stocks and bonds work
How do stocks work in comparison to bonds? Stock owners generate cash by selling stocks that increase in value or by reaping dividends. Both of these revenue streams are heavily dependent on company performance.
On the other hand, bond holders accrue interest on the loan and get paid when the bond matures. Unless something unforeseen occurs, their income is steady and it doesn’t rely so much on corporate profit.
How do stocks work?
Stockholders must follow the stock market statistics and trends if they want to stay relevant in the field and make a profit. Investing, selling, and reinvesting in shares is the basic principle of stock liquidity. Finding reliable stock brokers for beginners is a must if you are just now entering this complex world. Circumstantial awareness, adaptability, and staying informed are the key characteristics of a successful stock owner.
A simple example that would help you in understanding stocks would be a company that sells its stocks $20 a share. For a starter, you decide to invest $1,000 in that company’s stocks. That means, now, you own 50 shares. And if the total number of shares in that company is 200, that makes you a 25% owner of that company or corporation.
Now, let’s say the company you have invested in has made progress and has expanded. Instead of $20, each of your shares is now worth $30. That means that the new value of the stock you own is $1500 — that’s the amount you would get if you were to sell your stocks at the stock market. And that is without the dividends which you can receive in some cases. Unfortunately, if the value of your shares decreases, your investment will be worth less. Luckily, stock market return averages aren’t difficult to follow and can make your life much easier.
How do bonds work?
When it comes to comparing bonds vs stocks in terms of handling, bonds require slightly less involvement on your end. The main thing here is to opt for the trustworthy and legitimate institution to start with since your revenue will greatly depend on your legal bonds with that company or institution.
Here is an example. If there is a corporation that needs to raise cash, it will go to a public market and offer a coupon for a certain bond. That bond will have a par value, let’s say $2,000. So you will invest $2,000 with a promise of a 5% coupon. This 5% coupon entitles you to $50, twice a year, or in total $100 each year until the bond matures.
Bond exchanges may sound like a much safer option at first glance. Since basically, you are receiving the fixed income, all the while your revenue bond contract is on. However, bonding contracts are not risk-free. But more on this, in the risk and benefits section.
Bonds vs Stocks: Yield
In the investment field, yield represents the regular income inflow. It’s the money that you are receiving as an agreed-upon compensation for your involvement. In other words, something like the bank interest rate. The yield in both cases is usually measured in percentages, and it is tightly related to the market fluctuations — although the market affects stocks to a much greater extent. Still, there are some major differences in bonds vs stocks yield that are worth familiarizing with.
Bond yields or coupons are the whole reason or motivation for somebody to invest in bonds. Most of the time it is the main if not the only source of profit from a bonding agreement. A person investing in bonds is not a risk-taker who is looking to make an overnight fortune. They tend to be cautious investors who can make use of regular additional income. The whole point of bond yields is a constant current of reliable interest reimbursements.
Nonetheless, bond yields are not completely excitement-free. Investing in corporate bonds, you still have to follow your bonding corporation growth and bonds market. Depending on the type of bond you have concluded, these can affect your yield rates accordingly.
You may be signing a bond contract, but the bond yield is not written in stone. On the contrary, it is affected by the bond price.
Bond price is the value at which you would be able to sell your bond if you decide to sell it at the given moment. Any time the bond price increases, the bond yield decreases — it is another significant difference between stocks and bonds. This doesn’t seem to make sense at first, but it can be easily calculated with the following formula.
Current yield = Annual coupon payment / Bond price
Annual coupon payment here being those $100, or 5% of $2,000 that you agreed on in your bond. Keep in mind that the amount you get remains fixed; it’s the percentage of the bond value that changes.
Let’s say again you have invested $2,000 in a corporation with a 5% bond. If that corporation bonds were to increase to $3,000 eventually, your current yield would decrease. Since the current yield is calculated by the above-mentioned formula, with the annual coupon payment of $100 a year, your current yield is 3.33%, as opposed to the previous 5%.
But that is not all, there are other formulas and bond market statistics to follow to be able to predict current yield in detail. Not to mention bankruptcy risks when it comes to corporate bonds that can leave you without yield retribution.
However, overall, this market offers better yield stability than the stock market.
Corporate bond yields — Investment-grade bonds vs high-yield bonds
Your returns will mostly depend on the type of bond you have with the corporation in question. Corporate bonds explained in the following way could be easier to grasp and remember.
- Investment-grade bonds offer higher credit ranking and better security for the lower yields.
- High-yield bonds come with lower credit rankings, along with the lower security you are getting, while the return is higher.
With these variations, are bonds better than stocks after all? In short, when opting for higher-risk bonds, you can expect higher yields. But when opting for low-risk bonds, you are ensuring much greater peace of mind compared with investing in stocks or even high-yield bonds, for that matter.
Corporate yields, in general, can be paid out each month, four times a year, semiannually, or at maturity, depending on your bonding contract.
Government bond yields
Government bonds offer slightly more safety since governments can not go bankrupt, and they have backup tools for funds recovery like tax increment and similar. On the other hand, since the risk of involvement is lesser, the government bond yields are usually lower. You will usually receive government bond yields every six months until maturity.
Stock yields or dividends
One of the main differences between stocks and bonds is that buying stocks doesn’t necessarily assure additional income in the form of yield. Only in some cases, companies offer different types of rewarding payments called dividends.
A dividend is an optional premium, and companies are not obliged to pay it out. It’s a yield that the company would extract from incomes and give to the shareholders if it considers it the right move. Likewise, once the company is no longer in a position to pay dividends, it can cancel it without warning. Normally, this is to attract share buyers. Or to motivate them not to sell when the share prices are falling.
So as you can see by now, stocks offered with high dividends are to be evaluated with caution. Well-established, strong companies with blue-chip stocks will rarely pay dividends. It is mostly financially weak companies that need to promote their stock and bonds this way and raise funds at a high rate of interest.
Similarly, young startup companies would sooner withhold dividends until the business is well-established and the earnings are steady. Additionally, this is a good way for them to save more for reinvesting.
Stocks vs Bonds: Risks and Benefits
Here are some of the dominant risks and benefits of investing in stocks vs investing in bonds.
|Risks||Lack of consistent income||Limited income|
|Unpredictable share value decrease||Inadvertent yield decrease|
|Higher chances for bankruptcy||No yield in case of bankruptcy|
|Uncontrollable market crushes|
|Benefits||Owner’s rights||The right to choose among different levels of risks|
|Possible higher return than bonds||Initial investment return upon bond maturity|
|The higher number of investment possibilities||Consistent revenue can be used for small investments|
|Better chances for quick financial growth||Steady pace of financial growth|
So, as we can see from this table, buying either stocks and bonds carries its own sets of advantages and disadvantages. Stocks offer greater instant capital gain at a slightly higher risk. However, unreliable income and market fluctuations may easily scare new investors away despite the tremendous economic expansion possibilities.
On the other hand, we have bonds that involve slightly less risk and involvement but bring only limited returns. All in all, they offer a better sense of stability but at a significantly slower pace of financial growth.
Should I Invest in Stocks or Bonds?
If you are still considering which of these two options is a better choice for you, you can start by asking yourself these questions. Are you more of an active, risk-taking type who wants to make money through capital gains? Or do you prefer investing in something that will provide a lower but steady income?
We are all familiar with the Wall Street Crash of 1929, better known as the Great Crash, that lasted for a whole month. When it happened, the share values on the New York Stock Exchange had collapsed. The great stock market crash eventually led to the Great Depression, and it took the whole world years to recover.
Although the most extreme example, it is not an isolated one.
When comparing stocks and bonds, one can’t help but ask oneself whether the Recession of 1937–1938, Black Monday, or even the 2018 cryptocurrency crash are going to repeat soon?
Contrasting this are numerous bonding success stories and mutual funds such as FCSPX or AB Corporate Income Shares that generate profit at a very high rate.
Age can also play a factor. The closer to retirement you get, you should start focusing more and more on safer investments like bonds. Some financial advisors even go as far as saying that competing on the stock market is more of a young person’s game, while steady bonds are perfect mature-age investment options.
In the end, having in mind the difference between stocks and bonds, acquiring a few different resourceful strategies may be the ultimate solution. Staying informed, choosing the right moment, and diversifying investments, at least to some extent, can make the whole difference in your investment portfolio. And remember, you don’t have only two options but, rather, a countless number of combinations for success.