Last updated on March 9th, 2023 at 06:19 pm
The differences between stocks and bonds
When you dive into the world of investing, there are plenty of assets to choose from, such as, but not limited to, stocks, bonds, ETFs, mutual funds, and commodities. Of course, not all asset types are created equal – some are riskier, while others provide more opportunities and advantages. But which one should you choose to invest in? Below we break down the difference between two popular assets investors tend to add to their portfolios: stocks and bonds.
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What are stocks?
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Simply speaking, stocks are a representation of partial ownership of a particular company. So, when you are buying a stock, you are actually buying a tiny slice of the company itself. The more shares you purchase, the more of the company you own. Companies generally give out stocks as a way to fund their operations or raise capital to expand into new ventures. Stocks are generally purchased on the stock exchange, which acts like a middleman between investors and companies.
If the company consistently performs well, then so do the shareholders. However, on the flip side, if the company starts slipping, then a shareholder’s stock value will start to decrease. That being said, despite the risk, stocks generally provide more opportunities for investors to gain back a higher rate of return.
Within stocks, they can be further categorised into two categories. These include preferred and common stock. While they may seem similar, there are actually a few vital differences between the two.
Preferred stocks are stocks that pay a fixed dividend to shareholders on a regular schedule. While this means shareholders are prioritised in the event the company becomes bankrupt, they do not give any voting rights. However, they are less impacted by fluctuations in the market when compared with common stocks. This means they are less risky. On the other hand, while these stocks have the ability to appreciate in value over time, it is not as high as common shares. This is because the value of preferred stocks is inversely tied to interest rates. If the interest rate decreases, it will rise, and vice versa.
Common stocks instead offer voting rights in a company. This allows stockholders to vote on key business decisions, such as electing who is on the board of directors. While these stocks can potentially yield higher rates of return over long periods of time when compared to preferred stocks, they are directly tied to a business’s performance. If the business does really well, its price will increase. On the other hand, if the company performs badly, then the price will drop too. Moreover, in the event of the company going bankrupt, preferred stockholders will receive priority pay outs before common stockholders. If there are not enough funds left over, then common stockholders may even lose out on their initial investment. Overall, as they are considered a lot more volatile, they are considered riskier. That being said, they have the potential to consolidate capital appreciation over the long run, which can increase a stockholder’s investment value.
What are bonds?
Essentially, a bond is a loan from an individual investor to a corporation, government entity or any other kind of organisation. In exchange for your funds, you can receive payment from the borrower until your loan term ends (also known as the bond maturing). Then, the borrowers are expected to repay the loan in full. Investors can buy bonds directly from the government or through a brokerage firm.
As such, bonds are often considered safer investments, because there is more certainty. However, the downside is that investors sacrifice the potential opportunity to earn a higher rate of return elsewhere.
Here are a few of the key differences below:
Equity vs Debt: Equity is a popular liquid financial asset (which can be easily converted into cash). Stocks represent an ownership of equity, whereas Bonds represent an ownership of debt.
Capital gains vs fixed income: To take advantage of stocks, investors need to sell the shares at a higher price than they paid for. The capital gained is then taxed as either long-term or short-term. Whereas with Bonds, the most important part is its regular interest payments.
Inverse performance: When stock prices are rising, more people end up buying them, and so bond prices fall due to lower demand. Vice versa, when stock prices are falling and investors are looking for something with less risk, the demand for bonds increases, as well as their prices.
Which should you choose?
In the end, determining which asset is the right one for you will boil down to a few different factors. There is no thing as a one sized fits all approach. That being said, here are a few things that you should consider thinking about when picking assets to invest in.
Risk tolerance: This is by far one of the most important factors to keep in mind. Your risk tolerance level is the amount of loss you are willing to be okay with if an investment ends up not doing well. Some investors are prepared to risk huge amounts if they can get higher returns. Others are okay with hedging and making smaller investments. Your risk tolerance level can also change over time depending on your financial situation and age. For instance, if you are young, you may decide to invest in riskier assets because you have time to make up for any losses. If you are older, you do not have much time to recover from any losses, so you may choose to go the safer route instead.
Investment goals and time horizon: Your time horizon is the amount of time you expect to hold an investment before you need to access your funds. For example, say you are looking to buy a house in 2 years. This would be considered a short-term time horizon. Whereas if you were in your twenties and looking to save for retirement, that would be a longer-term time horizon. You also need to consider your financial goals. This can help to rationally guide any decisions you make so you can better allocate your funds to the right assets. Generally speaking, the shorter your time horizon, the more you should invest in safer and conservative assets. Conversely, if you have a longer time horizon, then you can invest in riskier ones. Again, there will always be exceptions depending on your situation or goals, so be sure to consult with a reputable financial advisor before making any financial decisions if you are still not sure what to do.