Differences between stocks and bonds: As a new investor it is easy to get confused between the different investments you have available. However, there are two investments that you need to know: Bonds & Stocks. Today, we are going to unveil the differences between these two types of investment vehicles, and help you figure out which one is best for your individual financial situation. What are we waiting for, let’s get started!
Here is a quick side-by-side comparison that breaks down the fundamental differences:
Stocks vs. Bonds: How do they compare?
Definition: Individual ownership in a specific company.
Return on Investment: Dividend Payment or Appreciation.
Who are Stocks Best for?
Stocks are best for individuals who have an appetite for risk. Stocks have the potential to return 100x your initial investment, but your return is never guaranteed.
Definition: The issuing of a bond is a means for a Government institution or company to raise money.
Return on Investment: Predetermined Interest Rate.
Who are bonds best for?
Bonds are best for individuals who want a low-risk way to invest their capital. Though your return on investment is guaranteed, it is often much lower. According to Morningstar, the average return of long-term Government bonds is between 5.0% – 6.0%.
As you can see, their are a few key differences between bonds and stocks, but fret not, we are about to take a closer look into how these two investment vehicles stack up against one another.
A Closer Look: Difference Between Stocks and Bonds
As you can see, both bonds and stocks are ways an institution can raise money. Stay with me, we only have a little bit more to cover.
What is a Stock?
Simply, a company issues stock when they are trying to raise further money for growth. Companies due this through a complex initial public offering.
The IPO phase is when individual investors, like you and I, can purchase shares of a company on the Stock Market (NASDAQ, NYSE, London Stock Exchange, ect.).
As an investor, when you purchase a share (stock), you immediately become a part owner. To Wall Street and Financial Institutions, this is referred to as owning equity.
For example, if you decide to log into your brokerage account and purchase one share of Microsoft (MSFT) stock for $136, well then congrats, you are now a part owner of this trillion-dollar company just like Bill Gates.
How Do Stocks work? Do Stocks provide a guaranteed return?
Stocks can be purchased through your brokerage account, and there are two primary ways you will make money: Capital Gain & Dividends.
A capital gain is when the share price of a stock rises higher than your initial purchasing price. Let’s say you purchase one share of Microsoft Stock (MSFT) for $136. After 6 months, you decide to sell the share for $150. Over the course of 6 months, you have successfully profited $14. A capital gain or capital loss is only recognized when you decide to sell your ownership.
A dividend is a payment to the shareholders as a result of the company’s earnings.
Think of a dividend payment like an interest rate. The company will pay you for holding onto your shares.
Dividends are either paid out monthly, quarterly, or annually. Usually, your dividend payment will be in cash form. Typically, your brokerage account balance will update automatically once the dividend is declared and offered to shareholders.
This reward keeps you invested, and it is also a chance for the company to prove to investors that they are turning profit and are continuing to expand their operations.
Dividends are a phenomenal opportunity as they provide a much safer investment for investors. On top of your dividend payment, your stock can also increase in price resulting in a capital gain.
What is a bond?
Plain and simple, the issuing of a bond is a simple way for the Government (Local, State, Federal), a Company, or a Financial Institution to raise money.
To break it down further, when a company issues a bond, they are essentially issuing debt. However, this issuance of debt is accompanied by an interest rate for their use of your money.
The bond market is second to none, it is a massive marketplace where billions of dollars are exchanged between institutions, companies, and individual investors.
How Do Bonds work? Do Bonds provide a guaranteed return?
A bond is part of the debt market where an entity will issue a bond when they need cash. Bonds can be purchased for a set dollar price (investors primarily refer to this as face value).
Then, depending on the length of the bond and its interest rate, the investor will begin to receive interest payments (investors primarily refer to this as coupon payments).
Simple right? Let’s understand the bond market a bit more with a helpful example.
You just purchased a 10-year corporate bond with a face value of $5,000 paying 3% coupon interest rate. The institution who issued you this bond, will pay you $150 ($5,000 x .03) each year until it fully matures. At the end of ten years, the company will return your principle investment, the full $5,000 you initially invested.
Here is a quick graph from Statista showing the average market yield on a 10 – Year treasury note from 1970 – 2018. The key takeaway with this graph is to show that bonds pay out a predetermined yield, which means your return on investment is guaranteed.
It is important to note,that investors can also profit from bonds if there face value increases.
What does this mean?
Again, let’s say you purchased a 10-year corporate bond with a face value of $5,000 paying a 3% coupon interest rate. Over time your bond market value increases to $6,000. You can then sell your bond for the current face value – $6,000 – and walk away with a $1,000 profit.
Why Should you invest in bonds?
Undeniably, bonds are a great resource for investors to employ in their portfolios. Though you may not immediately see the effects of bonds, they are a safe alternative comparatively to stocks. With a guaranteed return, bonds offer a healthy and stable return over a specific period of time. But remember, make sure to research all investment opportunities before you deploy your capital.
Summary: Difference between bonds and stocks
By now, you should have a clear understanding of the differences between bonds and stocks. Remember, bonds are essentially a loan (debt), whereas stocks are individual ownership in a company. Both though, are financing tools Governments and Company’s use to raise money.