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Probably the most common question that financial advisors get from their clients is: “Should I invest my money in stocks or bonds?”. For the majority of investors, the appropriate answer is seemingly a mix of stocks and bonds – but that is not always applicable for all. An investor has to first understand the difference between a stock and a bond as an initial step to decision-making about where to put their money.
Investing in Bonds vs Stocks: The Key Differences
We often hear financial experts and investor use the term “stocks and bonds” in the same breath. This gives many people the impression that they’re two sides to the same investment. The truth is, they are totally dissimilar.
You must know that they are very different investments, totally diverse from each other. People often pair them together when talking about investments because they complement one another. In fact, most financial experts will recommend that you create your portfolio with a balanced mix between the two. They might recommend other allocations like cash, real estate, and commodities, but generally, investors always start their investment journey through stocks and bonds.
We will look at both and why it makes sense to include them in your portfolio.
Ownership Vs Debt: Be a Lender or Be a Shareholder
Each share of stock that you buy makes you an owner of the company – but it’s just a small fragment of ownership. One share is one fraction of ownership in relation to the total number of shares outstanding.
For instance, if a company has one million outstanding shares, one share means one-millionth ownership in the company. As a shareholder, you become a quasi-partner/owner with some special privileges, including the right to vote on issues affecting the company. The better benefit is that a stockholder has a share in the profits of the business. If and when the company distributes these profits, you can receive them in the form of dividends. Companies issue their shares of stocks to raise their capital and this capital is their means to sustain and expand the business.
Another way for a company to raise money aside from selling its shares of stock is by issuing debt in the form of a bond offering. Bonds are technically evidence of indebtedness of an institution. The bond issuer can be a corporation, municipal government, county government, state, the Federal Government or even a foreign government.
Savings bonds are one of the safest investments, but over time investors have become a little more confident about taking on riskier investments, as you can see from this chart using FED Survey of Consumer Finances data
They have a fixed face amount that comes with a certain term, and a specific interest rate. An investor who buys a bond does not buy ownership into the company but lending money to the company through a piece of the company’s total bond debt.
Yield: Fixed Vs. Variable Returns
You will observe that stock prices usually go up or down. The reason for this is that the company’s profitability (or non-profitability) affects the price of the stock in the market. If a company is doing very well in making profits, the shareholders often stand to make a lot of money as well. If a company is losing money, the shareholders stand to lose money as well on their investment. In case the company’s situation becomes so bad that it can no longer meet its obligations and files for bankruptcy, the stockholders are usually the last on the list to get their money back. This means that they could lose all their investments in that particular stock. This is an inherent risk when you are investing in stocks.
On the other hand, if you put your money in bonds, you will receive an interest payment at specified intervals. It doesn’t really matter if the company is profitable or not – as long as they have money to pay their debts you will earn from your investment (except if the company goes bankrupt).
In stock investing, your returns will depend on the price of the shares which fluctuates according to any piece of positive or negative news about the company, or the economy. In bonds, as long as the issuer has money to pay their debts, they under obligation from the law to keep paying them. This means that whether the company performs well or not, as long as it does not file for bankruptcy, you can expect to receive your interest and principal payments.
The disadvantage is that if the company makes seven times the profits they usually make, you don’t get to participate in that – your interest income will remain as is. You can clearly see here that the two instruments demonstrate distinctly the risk-reward principle in investing.
Risk & Volatility
Potentially, stocks can give you higher returns than bonds. See if you are the type of investor who is willing to assume more risks than bondholders. If you prefer to get the benefit of being a partial owner of a company and have unlimited potential of rising stock value, stock investing is for you. Bonds are more stable and less volatile than stocks, but they usually don’t perform as well as stocks over a long period of time.
If you want to see how the “safe” bonds and stocks performed side-by-side historically, take a look. Since 1926, big company stocks did a whole lot better than bonds. They gave their investors an average annual return of 10%, while government bonds have recorded a measly average of only 5% and 6% per year.
Typically, investment volatility, a situation when the market shows severe and seemingly unexplainable price swings, is more of the mark of equities. Stocks fit this characteristic more between the two asset classes, so investors see them as the riskier investment than bonds. High-yielding bonds, on the other hand, although they have bigger interest rates than traditional bonds but greater risk of default, show market volatility that is similar to stocks than their U.S. Treasury counterparts. Unlike Treasuries and investment-grade bonds, the high-yield bonds do not afford the investors protection from equity price fluctuations.
Why Stocks Are Being Considered As Riskier?
Generally, stocks are riskier than bonds. While bond prices also swing in the market, even sometimes quite materially in the case of higher-risk market segments, the majority of bonds have remained stable. This means that investors are likely to pay back the full amount of principal at maturity, and there is much less risk of loss when compared with stocks.
Remember: when you diversify your investments and place money into both stocks and bonds, you effectively safeguard your investments while providing some opportunity for more-than-average returns in your stock portfolio.
Another crucial difference between a stock and a bond is what happens when a company files for bankruptcy. As we’ve mentioned earlier, the stockholders are the last in line during these types of situation. This perspective gives the bondholders the advantage over stocks because bondholders are one of the first groups of people to receive whatever money is left and/or what the liquidations sale of the company assets can raise.
It’s just after all the bondholders and other creditors get their money will the stockholders supposedly get any of their money back. In many cases, the company won’t even have enough money to pay the bondholders and creditors their full amount. This means that stockholders will be holding an empty bag when the smoke clears.
Keep In Mind: Not All Stocks/Bonds Are Equal
One of the great things about stock investing is that whether you’ve decided to buy individual stocks or mutual funds or exchange-traded funds (ETFs), your choices are plentiful. You have the option to pick value stocks, growth stocks, large-cap stocks, mid-cap stocks, small-cap stocks, domestic stocks, international stocks, and stocks with different levels of risks.
It's almost the same with bonds. You can have a diversity of choices when it comes to this debt instrument. There are government bonds such as Treasuries, municipal bonds, or corporate bonds. And within each of these categories, you can pick the type of maturity that suits your goals: from a few days to 30 years or more.
With the introduction of low fee platforms, stock investments have become more commonplace. In this chart using FED Survey of Consumer Finances data, it is clear to see that stock holdings are still dominated by the older age groups.
Under 35s account for an average of $27,000 in stock holdings, while those closer to retirement age and the retired hold over an average of $550,000. This suggests that stocks form an integral part of retirement planning.
Bonds also have a rating from AAA (highest grade) to C according to the creditworthiness of the issuer. Investors consider AAA bonds to be the safest because they have little risk of default since the issuers have a very strong capacity to meet their financial obligations. Junk bonds or those with a rating of BB and lower are the ones that have a higher default risk, but they tend to offer higher yields to compensate for the bigger exposures that investors assume when they buy these bonds.
How Should I Allocate My Portfolio?
There is no single answer to this question because we should consider a few factors. The first thing to regard is your age. Traditionally, when you are young, you should keep more of your assets in stocks because you have decades to learn and adjust to the volatility of the market. Plus, you can take advantage of the compounding power of stocks. As you get older, you should systematically transfer some (but not all) of your assets into bonds because they are more stable and will give you a more consistent, predictable income.
However, some investors have an above-average appetite for risk, while others would rather avoid market fluctuations to preserve their capital. If you feel at ease absorbing a little more risk in exchange for the potential of higher long-term returns, then you can put more of your money in stocks.
An investor can also invest in a stock or bond funds to lessen the risk of his investment. He can simply purchase shares in a fund which is made up of a portfolio of stocks and bonds. It spares the investor from having to personally select individual stocks and manage the portfolio. Funds also allow the investor to target a specific market segment. For example, he can choose to invest in high-tech, fin-tech, healthcare, energy, or mining from either domestic or international stocks.
What we’re really saying is: there’s no simple answer to the question. In truth, there is also a good variety of risk within stock investments. You can have speculative stocks and sturdy blue-chip companies which are miles apart when it comes to stock investing. We’ll have a separate discussion about that later.