What’s the Difference Between Stocks and Bonds?
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Stocks vs bonds – ask any financial planner which is better and you are likely to hear the equivalent of “why choose?”
This is finance-speak that describes the basic underlying strategy used to build the majority of investment portfolios today: diversification.
Diversification essentially means “balanced risk.”
From this definition you can also discern that stocks and bonds bring different strengths to the table.
In this article, we teach you about each security from the ground up and end with a comparison of stocks vs bonds and how to use each with different types of investing strategies.
What’s a Stock?
If you already know what a stock is you may feel tempted to skip this section.
We encourage you to read this entire article, however. You never know when you might learn something new and invaluable that changes how you develop your investment portfolio!
So let’s get started.
From an investing perspective, the word “stock” translates to mean “share of ownership in a company.”
Other terms that are often used interchangeably with the word stock include “share” and “equity.” At its simplest level, one unit of stock equals one share of ownership in a company.
What do you own when you choose to purchase a share of stock?
You do not own a unit of the company itself. Rather, you own one unit’s worth of that company’s assets (earnings).
So, why would a company want to sell you stock?
Each company’s reasons for wanting to raise funds by selling shares of ownership in their company will vary. But in general, companies often use stock sales as a way to raise operating capital.
To make sure you feel comfortable providing funding to a given entity, it will be up to you to do your homework before choosing which stocks you want to purchase.
But once you’ve determined which stocks to buy, where do you actually buy them? Of course, you can’t just walk up to Company A, knock on the door and ask to buy a unit of their stock. So where can you buy stock?
The majority of stock offerings are made through public stock exchanges. You can access these public stocks for sale by using an online e-trading “broker” platform or by working with a financial broker or trader.
Examples of public stock exchanges you may already be familiar with include the NYSE (New York Stock Exchange), NASDAQ (National Association of Securities Dealers Automated Quotations), and the AMEX (American Stock Exchange). There are 13 such United States stock exchanges in all.
In some cases, a private company may also choose to issue shares of stock.
There are different reasons for this. Some companies do not want to go public. These companies may still decide to issue stock but they may only make their stock available to certain select buyers, such as their own employees or a private investor.
Different Types of Stock
In this section we are going to look closely at the two different types of stock: common stock and preferred stock.
The name “preferred” stock is something of a misnomer. At the outset, the name makes it sound like preferred stock is a higher class of stock than its counterpart, “common” stock.
However, this isn’t accurate. It would be much more accurate to simply say that preferred stock is different from common stock.
Preferred stock typically comes with these general benefits and limitations:
- Preferential dividends payouts, both regularly and in the event the company faces a cash shortage or goes out of business.
- Dividends paid are for a set amount, which makes it easier to predict profitability.
- Preferred stock does not confer any voting rights.
- Preferred stock can be less easy to sell since it is in the minority and many investors prefer to buy common stock.
Here is an interesting fact about preferred stock. Since it comes with fixed (flat-rate) dividend payouts, some experts liken preferred stock to bonds as an asset category rather to than true stock.
Common stock is far more, well, common than preferred stock. When a company chooses to issue both preferred stock and common stock, typically a greater amount of common stock will be issued. Some companies may not issue any preferred stock at all.
Common stock typically comes with these benefits and limitations:
- Common stock holders will generally receive voting rights.
- Common stock can be easier to sell since it is more plentiful and offers variable returns with a higher potential for increased earnings.
- Common stock holders will always be in line behind preferred stock holders for dividend payouts.
- Common stock dividends are tied to the company’s profitability which means their dividends and profitabiity can fluctuate (increase or decrease).
Pros and Cons of Investing in Stock
If there is one ironclad rule of thumb in the world of investing, it is this: the higher the risk, the higher the potential (but not guaranteed) reward.
This is the textbook definition of diversification – balancing risk versus rewards. Stocks are widely considered to be one of the riskiest of all the mainstream asset classes.
However, stocks also historically outperform their less risky investment counterparts in terms of return on investment.
Here, you might well ask, with historical returns weighing heavily in favor of investing in stocks, how can they truly be called risky? The reason stocks are deemed high risk is because the issuing company’s own profitability is not the only factor that contributes to risk.
Market changes due to new technology, political instability, natural disaster and the greater global marketplace can all impact stock performance. As well, stocks are essentially intangible assets – they are not cash equivalents like Treasury bills or certificates of deposit – so their value is tied to market fluctuations.
Now let’s take a closer look at the major pros and cons of including stocks in a diversified investment portfolio.
Investing in stocks pros:
- Highly liquid
- High historical returns
- Option for dividends
- Stock-based mutual funds can offer the option for micro-diversification
- Can provide some protection against inflation
Investing in stocks cons:
- Stocks are inherently volatile
- Certain types of stock are even higher risk and less liquid
- Choosing stocks wisely comes with a steep learning curve
- Not a hands-off investment option
- Stock trading fees can potentially eat into any profits you may realize
Stocks Play An Important Role in a Diversified Investment Portfolio
Diversification in your investing portfolio can only be achieved through balancing potential risk against potential reward. This sounds easy in theory but it is far from easy to do in fact.
The best way to diversify your investment portfolio is to include a variety of asset classes. Some asset classes, such as stocks, tend to be more volatile and thus more risky. Other asset classes, such as T-bills or money market funds, tend to be less volatile and thus less risky.
By combining more risky and less risky asset classes together into a single investment portfolio, you guard against losses while also leaving the door open to greater gains.
You just learned about the potential benefits and limitations of the two major types of stock: preferred stock and common stock. So you now know that some types of stock are riskier than others.
You also learned an important, little-known fact about preferred stock: that some financial experts see preferred stock as the “bonds of the stock world.”
But what are bonds, exactly? Are they truly less risky than stocks? Are there different types of bonds? What place do bonds hold in a diversified investment portfolio?
What’s a Bond?
If a stock is a share of ownership in the assets (income) of a company, a bond is an IOU, or a signed agreement to provide debt financing.
While bonds are often assumed to be lower-risk than stocks, this is not always true.
Bonds, like stocks, are generally issued when an entity wants to raise funds.
The entity issuing the bonds can and does impact the risk level for a given bond. For example, a bond issued by a government entity is often inherently less risky than a bond issued by a corporation.
Remember when we said earlier that some financial experts view preferred stocks as the “bonds of the stock world?”
This is because both assets offer a type of fixed return on investment. Preferred stocks pay fixed dividends. Bonds pay fixed interest. However, both preferred stocks and bonds can fluctuate in value with market fluctuations.
In theory, bonds offer a guaranteed return even at the time of issuance. So an argument can be made that bonds are lower-risk than preferred stock since if a company goes bankrupt, bond holders will be in line for repayment ahead of preferred stock holders.
However, it is still also possible a company will run out funds before bond holders are repaid.
Common Types of Bonds
Different types of bonds exist and it is important to know the difference. Some bond types carry a lower inherent risk than do others.
We will review the four major categories of bonds next.
Government bonds that are issued by the federal government are confusingly called Treasury bills.
Even more confusingly, federal government bonds that will mature (fall due) in 10 years or less are called notes. Federal government bonds with longer maturity dates (10 years or greater) are called bonds.
Most confusingly of all, federal government bonds are sometimes also called treasuries or sovereign debt.
Municipal bonds are bonds issued by state governments or local governments.
When bonds are issued by federal government agencies, they are called agency bonds. Examples include bonds issued by Fannie Mae and Freddie Mac.
Companies and corporations may issue corporate bonds to raise funds for a variety of reasons.
Now that you know the four major categories of bonds, let’s take a closer look at the specific types of bonds.
Interestingly, a convertible bond is a bond that carries with it the option to convert its value into company equity (stock) at a later date.
In exchange for this option, investors who buy convertible bonds often agree to accept a lower interest payout (coupon rate).
Zero Coupon Bonds
Zero coupon bonds offer an interesting twist on the usual bond formula. Instead of offering a future interest payout (coupon rate), zero coupon bonds are sold at sub-par (discounted) value.
The best-known example of a zero coupon bond is a Treasury bond.
As the name implies, callable bonds can be called back (recalled or repurchased) by the company before their due date.
Callable bonds give the issuer flexibility to leverage lower interest rates to lower their debt.
In contrast, a puttable bond is one that the debt holder can sell back to the company before its maturity date.
Puttable bonds can entice buyers to invest in (lend money to) the issuing entity.
Pros and Cons of Bonds
Now let’s take a closer look at the major pros and cons of including bonds in a diversified investment portfolio.
Investing in bonds pros:
- Return on investment is essentially fixed.
- Bonds are generally less volatile.
- Bond holders will be paid before stock holders if the issuing entity must liquidate.
- It is often easier to assess the value of bonds because of how they are rated.
Investing in bonds cons:
- Lower potential for increased returns.
- Bonds tend to be less liquid (easy to sell) than stocks.
- Bond valuation moves inversely with interest rates.
- Some bonds have strict redemption rules that can impact profitability.
Bonds Play an Important Role in a Diversified Investment Portfolio
As you can now see, bonds, like stocks, come with varying degrees of risk. The degree of risk depends on the issuing entity and the bond terms.
What this means is that it is not enough to simply add stocks and bonds to your investment portfolio. Achieving a truly diversified portfolio also means selecting the right categories and types of stocks and bonds to balance out risk versus reward.
There are three major ratings bureaus that mete out risk ratings for different types of bonds: Standard & Poor’s, Moody’s Investors Services and Fitch Ratings, Inc.
Bond ratings can range from AAA to D. The lower the letter, the greater the risk. So-called “junk” bonds typically carry the lowest ratings, which reflect the issuing entity’s credit rating or longevity in the industry.
Difference Between Stocks and Bonds to Investors
To knowledgeable investors aiming to build a truly diversified investment portfolio, both stocks and bonds have their place.
Stocks, as you now know, are shares of ownership in the assets or net worth of the issuing entity. Bonds, in contrast, are debt instruments in their own right, with the potential for interest income as payment for the loan.
Preferred stocks carry with them lower risk and lower return than do common stock.
Government-issue bonds carry lower risk and potentially lower return than do corporate bonds and callable bonds.
Here, it becomes clear we are dealing with two fundamentally different asset classes. As such, both belong in a diversified investment portfolio.
One of the simplest ways to build a portfolio that includes higher and lower risk stocks and higher and lower risk bonds is by investing into funds such as ETFs (exchange-traded funds) or mutual funds. These funds may include a mixture of stocks and bonds or may be comprised of all stocks or all bonds.
Your life stage, career stage, age and risk tolerance will all dictate which types and how much stocks and bonds to add to your portfolio.
“Risk tolerance” refers to the amount of risk you can personally deal with, whether emotionally or at your age and stage of life. For general purposes, the closer you get to your expected retirement date, the less aggressive you want your investing strategy to be.
Conversely, the younger you are and the more years you have ahead of you to keep investing, the more aggressive you can be to maximize the potential for returns.
The four major investment strategies are often represented as follows:
This strategy is generally only appropriate for young investors who are just beginning their career and investing.
2. Moderately aggressive
A moderately aggressive strategy can be more appropriate once your portfolio has gained some traction and you have moved into a stage of life where you are taking on some significant debt such as a mortgage and/or you have some near-term big financial/savings goals such as having a child or planning for that child’s higher education.
3. Moderate growth
A moderate growth strategy represents a downshift as you mature in your career and see your major financial/debt obligations lessen. For example, perhaps your mortgage is paid off or your child graduates from college.
In the years just prior to your expected retirement date and into retirement, you may want to adopt a conservative approach to ensure your funds remain liquid and available as you need to access them.
By understanding the differences between stocks and bonds and the place each holds in a diversified investment portfolio, you can make full use of the benefits of each to grow your holdings and manage risk.