Investing is all about perspective as being a good investor is all about education. The value of investments can fall as well as rise, and you may get back less than you invested. Past performances has no guarantee of the future results because a sudden fall in share prices can hurt the short-term holders and it also creates opportunity for those with cash, but it has a little consequence for the investor.
Therefore, investors are always told to diversify their portfolios between stocks and bonds, but what’s the difference between the two types of investments?
How do Stocks and Bonds work?
When you own a company’s stock, you own part of that company or in other words, when a company issues stock, it is selling a piece of itself in exchange for cash.
For instance, a company has made it through its start-up phase and has become successful. The owners wish to expand, but they are unable to do so solely through the income they earn through their operations. As a result, they can turn to the financial markets for additional financing. One way to do this is to split the company up into “shares,” and then sell a portion of these shares on the open market in a process known as an “initial public offering,” or IPO. A person who buys Stock, is therefore buying an actual share of the company, which makes him or her a part owner, however small. This is why Stock is also referred to as “equity.”
Bonds are a form of long-term debt in which the issuing corporation promises to pay the principal amount at a specific date. When an entity issues a bond, it is issuing debt with the agreement to pay interest for the use of the money.
For instance, a $1000 bond with a 4% coupon would pay $20 to the investor twice a year ($40 annually) until it matures. Upon maturity, the investor is returned the full amount of his or her original principal except for the rare occasion when a bond defaults (i.e., the issuer is unable to make the payment).
Difference between Bonds and Stocks
Stocks and bonds represent two different ways for an entity to raise money to fund or expand their operations. However, Stocks pay dividends to the owners, but only if the corporation declares a dividend. Therefore, they are favoured by those with a long-term investment horizon and a tolerance for short-term risk.
Bonds, on the other hand, pay interest to the bondholders. Generally, the bond contract requires that a fixed interest payment be made every six months. Although, they lack the powerful long-term return potential of stocks, but they are preferred by investors for whom income is a priority. Also, bonds are less risky than stocks.
Advantages of Stocks
If your stock is excellent, you can really beat the market and make good money. You can pick the stock in an industry you understand. Also, your money is liquid, which means you can access it at any time by selling your stock.
Disadvantages of Stocks
Unfortunately, if a company does poorly, so does your stock. Because a stock isn’t diversified, that can mean disaster for you (although you can easily reduce your risk by picking bigger, solid companies).
Advantages of Bonds
Bonds are extremely stable, especially government bonds. You know exactly how much you’ll get when you invest in a bond. The only way you could lose money on a government bond is if the government defaulted on its loans and usually it doesn’t do that. It just prints more money.
Disadvantages of Bonds
Unlike stocks, bonds are hard to buy and sell as an individual. Also, the reward on an excellent bond is dramatically less than an excellent stock because they are very stable. Investing in a bond also renders your money illiquid, meaning it’s locked away and inaccessible for a period of time unless you’re willing to incur a big penalty to take it out early.
Which is Right for You?
Many people invest in both stocks and bonds in order to diversify. And deciding on the appropriate mix, totally depends on your tolerance for risk, and investment objectives.
Written by Tax Professionals