Bonds vs. Stocks: A starting guide for beginning investors
When discussing a diversified portfolio, stocks and bonds are always mentioned, and this is largely attributed to the different risks and opportunities the two have.
Deciding on the kind of asset class you want to invest in might be difficult, especially if you are a beginner. And you are not alone; this has been a problem for beginning investors ever since, more specifically to those who do not have any "concrete" knowledge about investing. This problem is hardly surprising, given that many do not appreciate investing because of their lack of understanding or fear because of the bloated stories of failure they read and heard.
People might know some bits of information about the terms like stocks and bonds since financial literacy is slowly gaining traction. Still, familiarity is not the same as having an understanding.
As a new investor, you might be looking at stocks and bonds or investments as one way to grow your wealth or to achieve specific financial goals. And these goals are not impossible, many investors grew their wealth through these means, and you might become one of them.
But before you can become like them through these means, you first need to understand that investing is not devoid of risks despite having myriad opportunities. There are risks, but if you know the market, the asset class you are investing into, like stocks and bonds, and the different strategies, the risks will be significantly minimized.
Bonds and stocks have been largely favored for years, and they are still now. Bond and stocks remain popular among investors despite the rising popularity of other asset classes like mutual funds, index funds, etc. These two are among the most traded assets on several platforms. But financial terms like stocks and bonds might be a little confusing for you. So, before deciding between the two, you need to know the differences to make an informed decision.
Difference between stocks and bonds.
Both stock and bonds are asset classes that are frequently traded on several platforms. But there is a prime difference between the two. Inventors, especially the new ones, should understand that the two generate profit differently. When investors buy stocks, they are having partial ownership of the company or corporation they invested in, and they will gain profit if the stocks increased in value. By selling the stocks that appreciated, investors can get back their investment and the profit. On the other hand, when investors purchase bonds, they are lending money to a company or government, and they will gain profit through the fixed interest associated with the bond they bought.
To understand it better, take a glance at the ways how these two works;
What is a stock?
A stock, also called a share, represents partial ownership in a company or corporation. Companies or corporations have millions or billions of outstanding shares. When you are buying a stock, you are buying a very little slice of the company, and by buying more stocks, you are equally buying a bigger slice of it. In simple terms, an investor who owns a stock owns a slice of the company. And the slice of the company or corporation an investor owns can be calculated by dividing the total number of stocks the investor holds by the total number of outstanding shares.
By owning stocks, an investor is positioned to gain or lose depending on the company's performance and other factors, including the stock price. For instance, if you bought 50 stocks from a company for a value of $100 each, therefore, you invested $5000. If, after several years, the company consistently performed well and the value of their shares rose to $125 each (25% increase), then the value of your investment would equally increase by 25%, which would give you $6250. So, if you sell it, you are positioned to gain a profit of $1250. But since the value of your investment is tied to the company's performance, if the price per stock fall, then your investment will also lose value.
What is a bond?
While stocks are a form of ownership, a bond is a form of debt. To be precise, bonds are loans you extend to a company or government. In this, there is no equity involved; the company or corporation simply issues bonds that an investor can buy. Bonds are like a form of agreement where the buyer (of bonds) will lend money to the issuer (company or government).
If you bought bonds, you would gain profit through the fixed-rate interest or coupon rate that the company or government will pay. This interest will be paid to you in a fixed period, after which you will get back the whole amount of money you lend through buying the bonds.
For example, you buy a $5000 bond with a 5% coupon rate for ten years. This means a $250 payment every year, evenly distributed among the months. After ten years, the total profit you gained from the interest will be $2500, and you will get your initial investment of $5000.
But bonds are not totally risk-free, it may be a low-risk investment, but it still has risks. For instance, if the issuer company went bankrupt during the bond period, you might not get the interest payments and your entire investment or principal.
The duration of bonds is dependent on the type of bond issued. Bonds' duration can range from a few days or up to 30 years like the 30-year Treasury bond.
Characteristics of stocks and bonds
When you hear investors talking about the equity and debt market, they are most likely talking about stocks and bonds.
Equity corresponds to the stocks issued by companies for fund generation or to raise cash. Companies need this cash to expand their operations. When investors buy equities or stocks, they become partial owners of the company; thus, their earnings will depend on its performance. By buying stocks, the investors are given a chance to enjoy the benefit of future growth of the company
On the other hand, buying bonds equates to extending a debt in the form of a loan. Buying a bond means entering into an agreement with the opposite party that you will provide a loan, but they need to pay it with interest within a fixed period.
Bonds and stocks generate profit through different means; capital gains and fixed-interest rates.
If you want to profit from stocks, you need to wait for the price to appreciate. If the stock price increases, you are positioned to profit since you can sell it at a higher price compared to the price when you bought them. Capital gains can be used as income and will incur capital tax gain.
Bonds, on the other hand, generate profit through the payment of fixed-interest rate
Pros and Cons of Stocks and Bonds
Like all other investments, bonds and stocks have two sides; they all present both opportunities and risks. Strategies can only do so much, but in the end, they cannot fully and perfectly avoid risks.
Pros of Stocks
- Some stocks provide dividends which can offset some drop in stock value. Investors can use these dividends to buy more stocks of the same company, other stocks or serve as an income.
- Stocks tend to earn more than bonds, especially in the long-term since stocks have the potential for higher returns.
- Some stocks provide voting rights for their holders.
Cons of Stocks
- Stocks tend to be riskier since it does not promise future returns. There may be potential for higher returns, but this remains a potential, and there is still the risk that it will not be realized.
- Stock prices can fall dramatically.
- In times of bankruptcy, some stockholders (common stocks) could be among the last to receive compensation.
Pros of Bonds
- Offers lower risk investment
- Resilient on interest rate fluctuations. Bonds have a less dramatic rise and fall compared to stocks.
- Certain bonds can provide both liquidity and stability
- In terms of bankruptcy, bondholders are prioritized compared to stockholders
Cons of Bonds
- Bonds lack the high return potential of stocks
- Bonds provided lower returns
Both bonds and stocks have strengths and weaknesses, and investors should capitalize on these. Stocks may be high-risk, but it also has high potentials, on the other hand, bonds are less risky, but it has lower returns. So, if you are a new and starting investor, you should know the value of diversification. Investing in both bonds and stocks works in favor of the investor. Having the two on your portfolio will give you have the guarantee that not all of your money will be lost in one swoop when a slump happened; therefore, you will have some means to still gain some returns.
It would be best if you also consider your goal and risk tolerance. If you are a retiree and need the money soon, then a portfolio with more bonds might be the best-suited one. A portfolio with more bonds also works for those who have lower risk tolerance. But if you are a young or an aggressive investor, then a portfolio with more stocks will be good for you. Time is your ally, stocks tend to have more significant returns in the long-term, so if you buy stocks when the prices are low and wait for them to appreciate, you are positioned to gain a lot of profit.