There are several investment products available in the market today. Considering the number of options you have, it can become confusing to choose one if you do not know how they work. Two of the most common investment products are stocks and bonds. Both serve different investors and help meet varying investment goals. If you would like to know how they work and how they are different, read ahead. Here is a deeper look at stocks and bonds.
What are stocks?
Companies issue shares to the public to raise cash that can help with future growth. Stocks give partial ownership in the company. Hence, when you buy stock, you buy a small part of the company in the form of one or more shares. If you buy more shares, you get a more significant part of the company to own.
Let us take an example here. A company has a stock price of $50 per share, and you invest $5,000. You get 100 shares of the company, and if the company continues to perform well over the years, its success will also be your success. The value of the shares will grow as the company grows. If the stock price increases to $100, the value of your investment will also double. If you choose to sell the shares, you will make a significant amount of profit.
But, the opposite is also true. If the company does not perform well, the stock value will fall, and you might end up with a loss. Stocks can be divided into common stock, corporate stock, equity shares, preferred shares, equity securities, and corporate shares.
Common vs. preferred stock
The two main types of stocks are common stock and preferred stock. If you own preferred stock, you will enjoy dividends and payouts before those who own common stock in the company. Hence, if you own preferred stock, you will have a higher claim on the company's asset payouts, which leaves the common stockholders with no guarantee of payment.
If you own common stock in the company, you will have voting rights at the shareholders' meeting, and you will also receive dividends while the preferred stock owners do not have voting rights. If the company goes bankrupt, the preferred stock owners will have a priority.
What are bonds?
Whenever a company or the government requires funds, they will issue bonds. A bond is a loan from you to the issuing party. The government or company is in debt when you purchase the bond, and it will pay back the entire amount at the end of the tenure. You will receive interest on the bond. But it is not entirely risk-free. If the issuing company goes bankrupt, you will not receive the interest payment and might not get back the principal amount.
Let us take an example here. You purchase a bond for $2,000, and it pays interest at 2% for 10 years. So, you will receive $40 in interest payment each year, and after the end of the bond period, you will receive the initial investment of $2,000 back, and you would have earned an interest of $400. You can make the most of the bond if you hold it until maturity. There is less uncertainty with bonds. You will know exactly what you are signing up for and the amount you will receive in the form of interest payments. It can become your passive income and a source of predictable income over a long period.
The bond period will depend on the type you buy, and the interest rate will also vary based on the type and duration of the bond.
Difference between stocks and bonds
You enjoy part ownership in the company when you purchase stocks, but bonds do not give you this ownership. A bond is a loan you give to the company. The significant difference between the two is the way you generate profit on investment. An investment in stocks will appreciate when you sell it later, while bonds will only pay fixed interest over some time. Both assets grow your money, but the way they do it is very different.
Fixed income vs. capital gains
You will generate income through stocks and bonds, but they work in different ways. If you want to make money from stocks, you will have to sell the company's shares at a higher price than you paid for when you purchased them. This will be your capital gain, and it will be taxed based on the period of holding.
Bonds generate regular income in the form of interest payments based on the distribution frequency. Corporate bonds usually pay monthly, semi-annually, quarterly, or at the time of maturity, while Treasury bills pay on maturity. Treasury bonds and notes will pay every six months. You can also sell the bond in the open market if the price of the bond increases. But for most conservative investors, fixed income is attractive about bonds and prefer to hold it until maturity.
A key difference between stocks and bonds is their inverse relationship in terms of their price. If the stock price rises, the cost of the bond will fall, and vice versa. When the prices of stocks are rising, more people are going to buy them to make the most of the growth, and this is when the cost of bonds will fall due to low demand.
Conversely, when the stock price is on the decline, investors will want to look for low-risk and low-return investments like bonds, and this is when its demand rises, and so does the price. When stocks are at their worst, bonds tend to have their best performance.
The performance of bonds is also related to interest rates. If you already own a bond and the interest rates drop, your bond will become more valuable as the new bonds will have a lower interest rate than yours. Further, higher interest rates mean that the new bonds issues will have a higher yield than yours, which will lower the value and demand of your bond. The interest rates vary from time to time based on the economic cycle. Low interest rates tend to increase the value of the bonds.
Risks and rewards
The significant risk with stock investment is the decline in its value after you have purchased them. You will come across several reasons the stock fluctuates, but if the company's performance does not live up to the investor expectations on the stock exchange, the stock price could fall. There are many reasons a company’s business could decline, which makes stocks riskier than bonds. But with higher risks come higher returns.
The U.S. Treasury bonds are much more stable than stocks, but the lower risk comes with lower returns. Government bonds and Treasury securities are usually risk-free because the U.S. Government backs them. Corporate bonds, on the other hand, have a high level of risk and return. The ability of the company to pay back debt is seen through credit rating, and it shows the chance of the company going bankrupt. The investment-grade corporate bonds have a high credit rating but low risk and low return, while junk bonds have low credit rating with high risk and high returns.
The risk and return of each investment instrument can help choose the amount you want to invest in each. Bonds have a unique role and can be a low-risk, fixed-income investment.
Selling bonds vs. Selling shares
You can sell bonds in the bond market for capital gains when their value rises. If you can make more money than what you paid for them, you can sell the bonds. It can happen if there is a change in the interest rate, a better rating from the credit agency, or a combination of both.
Similarly, you can sell the stock in the open market whenever you want to. Once you open a brokerage account to purchase stock, you can use the same account to sell them.
How to invest in stocks
Purchasing stocks is easy. You can either buy the stock when the company files an initial public offering (IPO) or purchase the stocks of your choice from the secondary market. You need to open an online brokerage account and link your bank account. You can then proceed to make the purchase.
A mutual fund is a bundle of stocks in a single investment portfolio, and a professional fund manager manages it. Instead of worrying about which stocks to buy and how they will perform, you can invest in a mutual fund. It allows you to invest in stocks, bonds, and securities. Mutual funds are a great option for investors because they are managed with certain goals in mind. You will have to pay a commission on the earnings you make as the fund is professionally managed.
As explained above, an ETF is a low-cost option, and they are passively managed as compared to mutual funds. If you want to diversify the investment strategy and reduce risk, ETFs are a great choice.
Whether you choose an ETF or mutual fund, the component of the investment strategy will be the securities that match an index fund. An index fund is a portfolio designed to meet a major market index like S&P 500 or Dow Jones. Index funds are passive investments and offer a low-expense option that is guaranteed to grow the savings. They are ideal for novice investors. An index fund will let you bet on the market. So, when you invest in the index fund, you bet that the market will go up even if the companies rise or fall. There is a lot of peace of mind that comes with an investment in index funds.
How to invest in bonds
One can purchase bonds from an online brokerage like Fidelity or Stash
. You can also buy from the investors who are looking to sell. When you buy it from the underwriting investment bank at the time of offering, you can also enjoy a discount on the bond's face value.
The Treasury Direct website set up by the Federal Government has a program that allows you to buy bonds without paying any fees to the broker.
An exchange-traded fund or ETF will purchase bonds from the companies, and they will have different bonds that provide exposure to specific industries and markets. An ETF is a great choice if you do not want to buy in large increments and want to diversify.
The Bottom Line
You will come across several tips to determine how to allocate the bonds and stocks in the portfolio. There is a simple idea behind it. As you approach the retirement age, it helps protect the nest egg from the market swing by allocating a large part of your funds to bonds and less to the stock market. It also boils down to risk tolerance. If you are comfortable with high risk, you can consider investing in stocks at any stage in life. However, if you do not want to take high risks and want a stable, consistent return, it is best to choose bonds.
Only you can decide whether you should invest in stocks or bonds. It helps with diversification and will ensure that you have different types of investment instruments in your portfolio. If you are keen on regular income through interest payments, you should opt for bonds. However, if you have a risk appetite and can handle market volatility, proceed with stocks. An ideal combination of the two will help build a diversified portfolio.