Differences between stocks and bonds; A complete guide
Most individuals when they are starting with investing, tend to have a lot of questions. And one of the most common questions of them all is – should I invest in stocks or bonds, or if I invest in both, how much should I allocate to each one?
For a lot of people, their investment journeys end right at that point. Because they look into stocks and bonds but can’t seem to decide which is a better investment, so they put off investing altogether. And they think they’re better off putting their money in savings accounts.
Here’s the thing – savings accounts with their 0.04% interest are not going to make you any money – in fact, they don’t even save your money when inflation rates are around 2%.
The point is, you should get started with investing as soon as you can. And we’re here to help you do that.
In this article, we’ll talk about the difference between stocks and bonds and which might be the better investment option for you.
Stocks and the stock market
Stocks are securities that represent partial ownership in a company. When you buy a share of stock, you’re buying a portion of the company. Hence stocks are also known as equity securities. For example, if you buy 10 shares of Microsoft stock, you are buying a portion in the company that is equivalent to 10 shares. Because Microsoft has more than 7 billion shares, your stake might be insignificant. Nevertheless, you’re still a shareholder of Microsoft.
A stock market allows companies to raise money from the public. Companies exchange a small stake in the company for cash. This allows them to raise huge amounts of cash that can be used for expanding the business and grow the company. For investors, it is an opportunity to be a part of the company and get rewarded.
A stock exchange is where individuals come together to trade in stocks. Stock exchanges act as an intermediary between companies and investors, where the company can list their shares and the individuals can trade them. New York Stock Exchange is one of the largest stock exchanges in the world and lists some of the biggest companies in the US.
Stock markets in the US are heavily regulated. The Securities and Exchange Commission (SEC) oversees the activities of stock exchanges and has set strict rules to ensure the smooth and transparent functioning of the market.
Bonds and the bond market
With bonds, you’re lending money. When you invest in a bond issued by a company, you’re basically lending them money with a promise that the money will be returned to you along with interest. It’s almost the same way a bank pays its debtors.
Assume you invest $1,000 in a bond that pays 2% interest for the duration of 5 years. During this holding period, you’ll be paid $20 (2% of $1,000) every year. And at the end of the duration, you’ll be paid back the initial investment i.e. $1,000, so you end up with a total of $1,100.
The bond market does not have a centralized location like a stock exchange. Bonds are mainly sold over the counter (OTC). Bonds are also given an investment grade by credit rating agencies like Moody’s and Standard and Poors. These ratings help investors understand how risky a particular bond is.
Generally, there are three types of bonds;
- Corporate bonds
- Municipal bonds
- High yield bonds
Corporate bonds are the ones that are issued by private and public companies. These generally have a high credit rating, meaning that they’re likely to pay you back your money along with interest.
High-yield bonds, on the other hand, offer higher yields but have a low credit rating. So they’re more likely to default, and hence offer higher yields for the increased risk.
Municipal bonds are the ones issued by states, cities, and other government entities. US Treasury securities are an example of it. Treasury bonds are considered the safest form of investment, as they are backed by the US government, making them a popular choice.
Difference between stocks and bonds
By now you have a decent idea of the differences between stocks and bonds. Anyway, we’ll take a closer look at how they are different.
Making money; bonds vs stocks
Capital gains and dividends
When it comes to stock investments, there are two ways you can make money; capital gains and dividends. Capital gains are when you make money from the price appreciation of stocks over time. In simpler terms, you sell the stocks for a higher price than you bought them for. Capital appreciation occurs when the underlying company performs well; the company generates more revenue and profits, expands the business, enters new markets, etc. When a company performs well, investors will be willing to pay more for its stock, and you capitalize on that.
The second way to make money from stocks is through dividends. These are cash payouts paid by the company to its shareholders. A portion of a company’s earnings is distributed to shareholders in the form of dividends as a token of appreciation for investing in the company. These payouts are made at frequent intervals, usually annually or quarterly, although some stocks pay a monthly dividend. So you invest in stocks that pay a dividend and get paid frequently.
Notice I said ‘stocks that pay a dividend? That’s because not all stocks pay a dividend. Instead of paying shareholders, the company might reinvest those earnings into R&D, expansion, or acquiring businesses. And that can drive up the price – which ultimately benefits the shareholders.
And both capital gains and dividends can be reinvested into equities which will compound your returns over time.
Similar to stocks, investors can make money from bonds with capital gains or interest payments. Bonds, just like stocks, can be sold on the market for more than you bought them, and pocket the difference. However, the primary source of income from bonds is through interest payments.
Generally, interest payments will be paid every year, distributed throughout the year. This predictable regular income is what attracts most investors to bonds. Hence bonds are considered as fixed income securities. Also, with bonds, the initial capital is guaranteed, as long as the bond issuer is solvent. As for government bonds, they are backed up by the US government, so it is considered the safest form of investment.
Ownership; equity vs debt
When you own stocks, you become a shareholder in the company. That means you own a small portion of the company. Depending on how well the company performs, that portion could be a lot more valuable in the long run. And you can hold on to it, as long as the company exists, and get rewarded all the while. As a reason, stocks are the most popular liquid financial asset in the US.
With bonds, however, you don’t own anything. When you lend money to a company, you’re not given a stake in the company. Instead, you’re merely promised that you’ll be returned the capital along with interest.
Risks and rewards
Whether you invest in stocks or bonds, there are risks and rewards involved in both these. Let’s look at it in more detail.
The risk with stocks starts with the returns. For stocks, returns are not guaranteed. If anybody tells you that a certain stock is a ‘guaranteed’ ten-bagger, run for your life. Because stock price can move up, down, sideways – pretty much in all directions. This is especially true in the short term. You can invest in a promising company and still lose money in the short term.
If you would like to know more about how a stock market works, check out this article.
A lot of factors can affect stock prices. It could be issues within the company in question, or the industry, or the economy in general. Remember March 2020? Between March 4 and March 11, the S&P 500 index dropped by 12%. On March 12, the S&P 500 plunged 9.5%, its steepest one-day fall since 1987. This was due to the outbreak of the global pandemic.
But if you take a step back and look at the markets, you’ll see that the markets rise in the long run. The S&P 500 for instance, was back on its feet, and by January 2021 it had reached a new record of 3,849.62. And as of the time that I am writing this, it’s at 4,352, up 88.83% from its lowest in March 2020.
The point is – investing in stocks can be extremely rewarding. Especially if you hold on to your stocks for a longer period of time, say more than 20 years. Consider this for example; if you had invested $8,000 in the S&P 500 index in 1980, your investment would be nominally worth approximately $783,086.76 in 2021, despite several market crashes and downturns along the way.
And this is only the market average. You could have achieved this just by passively investing, using an index fund, or a broad market ETF. Also, when it comes to stocks, there is virtually no limit to the returns you can generate. Using a proven investment strategy such as value investing can bring returns substantially higher than the market average.
There are also dividends, which can provide a steady stream for as long as you hold the stocks. And if you can reinvest those dividends, your returns will compound over the years, and it can bring massive returns to your investment portfolio.
Let’s assume you invested $100,000 into an ETF that tracks the S&P 500 and remain invested for 20 years. Also, you chose to reinvest your dividends using a dividend reinvestment program (DRIP).
Assuming a steady dividend yield of 2% and an average annual return of 8%, this is what your investment will look like in 20 years, compared to the one where you did not reinvest your dividends.
As you can see, there is a big difference in the value of the investment after 20 years. In fact, you earned 48% more by reinvesting your dividends for 20 years, than the one where you did not reinvest.
Bottomline – dividends or no dividends, in the last 15 years stocks have outperformed every other asset class with an average annual return of 9.88%.
Bonds help you preserve capital and earn a steady income. You get an additional stream of income with the regular interest payments from the bond. And these payments are generally tax-deductible, which is an added benefit. On top of that, certain bonds such as the Treasury bonds can be the safest investment during bear markets.
Having said that, there are downsides to bonds as well, the most important one being that the returns are limited. The returns from bonds are guaranteed, but they are limited and lower compared to other asset classes. In fact, bond yields are so low that when accounted for inflation, the returns might be marginal or in some cases – none.
Liquidity is another important factor when it comes to bonds. Bonds can also be bought and sold like stocks, but they are less liquid, meaning they cannot be easily converted into cash. Bonds are traded on over-the-counter (OTC) markets, which means regular investors like me and you are less likely to participate in trading bonds.
Rising interest rates add to this issue. When interest rates rise, bond prices fall. Because the newer bonds will be more appealing to investors, as they offer a higher rate of interest. And when you try to sell a bond with a lower interest rate, you might have to do so with a loss.
Which is best for you; stock or bonds?
Your investment goals, timeline, and risk tolerance are some of the factors that need to be considered before deciding what’s best for you.
You might be investing with a specific goal in mind that needs to be achieved within a specific timeline-like buying a house. Or you might be investing for retirement. Also, how much risk are you willing to take; are you okay with your investments going down 10-15% at times? What about your timeline – are you flexible with your timeline, or do you have a timeline that must be met at all costs?
All of these need to be considered, before deciding whether to invest in bonds or stocks or both. But as a rule of thumb, when you are looking for the capital appreciation you should go for stocks. On the other hand, if you are looking to preserve your money, and get low but consistent income from your investments, maybe you should go with bonds.
You can also mix it up with stocks making up the majority of your portfolio. This is applicable when you’re looking to limit your downside, or simply put, protect your investments, rather than trying to grow it substantially.
Stocks and bonds can be beneficial to your portfolio, whether to go all-in on one of these, or have a mix of both depend on your goals, timeline, and risk tolerance.
When it comes to growing your money, stocks have the upper hand, as it has historically outperformed all other assets. However, if you’re hesitant about going all-in on stocks, you can go with a mix of both, with allocations such as 70% stocks, and 30% bonds or similar.
The important thing is that you invest in the market, rather than depending fully on savings accounts to save your money. Have a long-term view when it comes to investing in stocks, and also investing in general, and do your homework when investing in any asset, and you’ll be good.
While this is enough to get started, you’ll need more information as you sail through your investment voyage. Here is The 8-Step Beginner’s Guide to Value Investing to help you.
PS: The book features the 20 best stocks & ETFs to buy and hold for the next 20 years that can give you a jumpstart.
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