Stocks and bonds have been some very popular investment opportunities for a long time and in this article, I uncover the question: Which best describes the difference between stocks and bonds?
Let’s look into it 🙂
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The key difference between stocks and bonds
The key difference between them is that one is ownership, and one is debt.
Stocks are essentially ownership in a share of the company – usually a very tiny portion. Bonds, on the other hand, are a form of debt, and the entity that issued the debt promises to repay eventually.
Essentially, a bond is a form of a loan but is usually issued by extremely large entities like governments, where the risk of default is very minimal. A bond is also usually traded publicly, meaning you can buy the bond from other people.
Corporations can also issue bonds, which is why you may have heard the term capital structure in reference to its balance between stocks and bonds.
A company can raise money through both. They can sell shares to raise money through equity. Or they can accept capital from bond investors in a promise to repay them later.
Which one is safer as an investor?
As an investor, your money is safer with bonds.
If a company collapses and is going out of business, the shareholders are the last person to see any money. On the other hand, bondholders are the first to be repaid. Stocks are therefore riskier in the event of a business collapse as well as an economic collapse.
The differences it makes as an investor?
Generally, shareholders get higher returns given their increased risk, but here is why…
Bondholders receive periodic interest payments. These are usually guaranteed structured income. On the other hand, shareholders can receive dividends.
If a company has an incredible year of high profits, they’re not going to reward bondholders with some bonus repayments. However, they may increase their dividends for that year to keep those with ownership happy.
Furthermore, shareholders have voting rights, which bondholders do not have. This means that shareholders can have an influence on the company. This can ensure their interests are protected and they can make more money in the future.
Lastly, if the company becomes a lot more profitable or valuable, the shareholder can gain more by trading away his position. Stocks change prices constantly (when markets are open) and can mean shareholders can receive a lot more money for the share than they purchased it for. Bond prices do not fluctuate like this.
What are the returns of each?
As you can guess from above, stock returns can differ widely. The average dividend yield of the S&P 500 is 2.2%. These are fairly safe investments, as they’re very high-cap companies.
Safe bonds, i.e. long-term Government bonds can often be lower than this.
Of course, though, the S&P 500 index has doubled in five years though, meaning many shareholders have doubled their wealth from the shares. This is the risk though because the market can be volatile.
The key to both is longevity. To get a good bond rate, tying up your money in long-term corporate bonds can often get you over 6%.
Likewise, the stock market is always fluctuating, but long-term returns are proven exceptional in emerging markets and most of the key markets.
Ideally, having both (and from a mixture of companies in a mixture of markets) is the best way to diversify risk whilst maintaining a high return.
You can also go for index funds when you invest in the stock market to ensure a good diversification. In my opinion, it will also lower the risk and it’s time-consuming and complicated to pick individual stocks.
Converting bonds to stocks?
It’s actually possible in some cases that bonds can be converted into shares if this feature was agreed on before issued. This conversion usually occurs when a company’s capital structure hits a certain ratio of bonds to stocks.
This has been a provenly good way to reward bondholders with an eventual voting rights and ownership in the company.
Which one is best?
To answer the question “Which best describes the difference between stocks and bonds?” you need to look at your plan.
If you want to strive for an offensive strategy and are willing to accept the risks along with that, then investing in stocks offers the most opportunity.
This is because you can invest in small-cap tech stocks for example, that have huge potential. The issue with these sorts of companies is that they’re often one patent away from either a huge success or losing your money and going bust.
Of course, you can diversify with many small investments, but then you’re not going to have much time to research each and it becomes more of a gamble. You may as well just track a small-cap index fund so you can benefit from the success of the market itself. This though may require faith in the long-term, and sticking through some difficult times of high volatility.
If you are interested in seeing how I have invested then you can follow my investment portfolio. I keep it updated monthly.
When I invest it’s in alignment with my 7 steps plan to financial freedom to make sure I reach my goals.
I hope you liked this article covering “Which best describes the difference between stocks and bonds?” 🙂
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