The Difference Between Stocks and Bonds
When considering investment opportunities, bonds and stocks are likely to be the first which occur to most. Whilst both are bought in the hope of generating a return, the way in which they do so is very different. So, what is the difference between stocks and bonds? And what does one need to consider before investing in stocks and bonds?
In this article, we will examine bonds vs stocks. We will highlight some of the key differences which those considering investing in stocks and bonds should be aware of and demonstrate how to invest in stocks and bonds!
Table of Contents
What Are Stocks and Bonds?
Before we examine the difference between stocks and bonds, let’s firstly familiarise ourselves with the meaning of stocks and bonds.
When investors buy stocks, they are buying a portion – or a share – of a company and essentially become part-owner of that company.
Therefore, when it comes to stocks, the success of an investment is dependent on the success of the company. The better the company performs, the better your investment will tend to do and vice versa.
Bonds are what is known as a “fixed-income” instrument. When you buy a bond, you are lending money to the issuing entity – typically a corporation or government - which they undertake to repay you on a fixed date in the future, together with any applicable interest in the interim.
Straight away, a key difference between bonds and stocks should be apparent, namely that - with a bond – the repayment amount is fixed from the outset and the future success of the bond-issuer will not impact this figure.
However, that does not mean that bonds are without risk, something we will look at more closely later.
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The Difference Between Stocks and Bonds
Now we understand the meaning of stocks and bonds, what are their main differences?
Income vs Capital Gains
Whilst the purpose of both investments may be the similar – to generate returns – stocks and bonds achieve this in very different ways. One via regular, fixed income and the other mainly by capital gains.
Bonds generate income for investors through interest payments, known as coupon payments, which are fixed at the beginning of the bond’s term. These coupon payments are made regularly until the bond’s maturity; how regularly depends on the bond in question. Once the bond has matured, the full amount the bond was originally sold for, the principal, is returned to the investor.
Many stocks also make regular payments to shareholders in the form of dividends. Unlike coupons, these payments are not guaranteed; they can vary from one period to another and may not be paid at all. Generally, younger, fast-growing companies tend not to pay dividends (or to pay smaller ones), whereas many larger, more mature companies do – providing they make a profit.
In order for an investor to profit from stocks, they need to sell their shares for a higher price than they originally paid for them, or to collect dividends. This means that - unlike bonds, which have a fixed rate of return baked into them – stock market investors do not know beforehand exactly how much money their investment will generate for them, if it generates anything at all.
With bonds, there is a predetermined limit to how much your original investment will generate. With stocks, there is, in theory, no limit to your potential returns.
Debt vs Equity
When you buy a bond, you are lending money to the bond-issuer. In this way, a bond can be thought of like an ‘IOU’ between the investor and the bond-issuer. Bondholders have no influence over the borrowing entity or any stake in their business - they are simply a lender who must be repaid at a fixed date in the future.
This is another key difference between stocks and bonds. Buying shares in a company buys you equity in the company; as a shareholder, you are a part-owner. This means that - as well as sharing in the future success, or failure, of the company – you also usually receive voting rights, enabling you to have your say on how the company is run.
Risk of Bonds vs Stocks
In the first highlighted difference between bonds and stocks, we said that, whilst bonds have a fixed rate of return, stocks have no limit to their potential return.
However, it is important for anyone considering investing in bonds vs stocks to understand that the risk profiles of the two are very different. With their higher potential return, stocks also tend to carry a higher risk.
The main risk associated with investing in stocks is that, after you have purchased them, the share price falls. This usually happens when a company underperforms, but it could also be caused by a variety of other unrelated factors.
For example, a company’s share price could be negatively affected by any of the following:
- A scandal which tarnishes the company’s reputation
- It operates in an industry which becomes unpopular
- Its business is hampered by new regulations
Although bonds are typically seen as the “safer” investment between the two, it is important to remember that they are not without risk. Bonds carry the risk of default, in other words, the risk that the bond issuer fails to pay the bond coupons or the principal.
A bond’s level of risk depends on the bond issuer. At one end of the spectrum, you will find investment grade bonds, which are issued by entities with a high credit rating and are, therefore, deemed low risk. However, these bonds will also have a lower interest rate.
At the other end of the spectrum, you have junk bonds. These bonds will tend to have higher coupon payments, but they are issued by entities with low credit ratings and, therefore, carry a higher level of risk.
Nevertheless, when weighing the risk of bonds vs stocks, it is also worth considering that if a company goes into liquidation, its bondholders will be prioritised over shareholders when distributing any remaining funds.
Bonds vs Stocks: Which Is Better?
So, which is better stocks or bonds? There is no real answer to this question. As we have seen, stocks and bonds are two very different instruments which can be used to achieve different goals.
Bonds are potentially more suitable for income investors or investors with a lower appetite for risk. On the other hand, stocks might be more appropriate for investors targeting growth and who are prepared to take on the additional risk associated with investing in stocks.
However, it is not necessarily a question of stocks or bonds. Many successful investors will tell you that a healthy portfolio is made up of a mixture of both stocks and bonds. Investing in different asset classes provides an investor with diversification, which is an integral part of risk management.
How to Invest in Stocks and Bonds
With an investing account from Admirals, you can invest in over 4,500 stocks from around the world as well as a variety of bond ETFs (Exchange-Traded Funds). Bond ETFs use investor’s money to invest exclusively in bonds, meaning that you can gain exposure to a number of bonds with one investment.
Follow these 4 steps to learn how to invest in stocks and bonds with Admirals:
- Register for an Invest.MT5 account and log in to the Dashboard
- Next to your account details, click ‘Invest’ to open the MetaTrader WebTrader
- Search for an instrument and click the symbol to open a price chart
- At the top screen, select ‘New Order’, enter the volume and click ‘Buy’ to send your order to the market
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An Invest.MT5 account allows you to invest in more than 4,500 stocks and over 200 ETFs from around the world! Click the banner below to open an account today:
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.