Such terms as stocks and bonds often pop up when people talk about investments on the market. However, it’s critical to understand the difference between these terms since they pose different risks and returns.
We have prepared this article to help our readers differentiate between bonds and stocks. In this article, you will learn about the benefits and risks of each type of investment.
What are Stocks?
Stocks reflect partial ownership, or shareholder’s equity, in a business. If one purchases stock, they’re buying a tiny part of the business. One may buy one or several shares. The more shares a person buys, the more he owns in a company.
Suppose a company has a stock cost of $100 per share. A person invests $10,000, so they own 100 shares each $100. During the next few years, the company performed well, and the stock price increased. For instance, now its price is $150, the calculator will show that the owner of 100 shares now owns $15,000. If he sells all shares, the profit will be $5,000.
Logically, if the company performs badly and the shares’ price goes down, the investor may lose money if they choose to sell stock. Stocks are often referred to as corporate stock, corporate shares, common stock, equity securities, or equity shares.
Businesses often open the possibility to buy their stock for a plethora of reasons. One common reason is to gain cash to use when optimizing the business.
What are Bonds?
A bond is a different financial instrument. Instead of buying a company’s share entirely, a person offers a loan to the company. In simple words, the company or even the government is in debt if you buy bonds.
People buying bonds don’t own some share in a company. Instead, they receive interest on the loan for a set period. When the period is over, the company or government pays back the full amount a person bought the bond for.
So, it’s a different option to gain profit, mainly through interest payments. Investors should understand that if the company goes bankrupt, they might not get the full payment on their bonds.
Suppose a person bought a bond for $12,500, and receives 3% annual interest for 10 years. It means the person gets $375 every year, and this payment should be evenly distributed throughout the year.
When the ten-year period is over, the investor gets $3,750 in interest, plus they get back an initial investment of $12,500. The process of keeping the bond during the entire period is called “holding until maturity.”
Unlike stocks, bonds give a passive income during a set period. Moreover, investors can predict their income and the results of their investments. With stocks, investors can only try estimating the potential progress of the company in the future, and thus, the stock’s price increases.
The bond’s duration depends on the bond type. Typically, the bond’s duration may last from several days to 30 years. Similarly, the interest rate (or yield) depends on the bond type and duration.
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Bonds vs. Stocks from an Investor’s Point of View
When it comes to stocks, they offer benefits only if the company performs well. If the business is at risk of bankruptcy, investors may lose their money. But if the business performs well, the investors may gain great profit if they choose to sell their shares. Stocks belong to long-term investments.
Bonds offer a short-term return thanks to interest payments. Typically, investors choose to buy bonds to increase their income with minimal risks. Bonds are more or less predictable, even though there are risks of losing money if the company goes bankrupt.
Which Type of Investment to Choose?
So, how to choose the type of investment? Consider the following factors:
- risk tolerance;
- the period you want to gain money;
- investing objectives.
When it comes to risk tolerance, consider how you react when the price of stock drops. Some people immediately choose to sell a stock, and then they regret this decision when, in the future, the price increases. Stocks aren’t a good option for people close to retirement, either.
If an investor has time and wants to gain profit rather quickly, they may consider buying stock when its price is low and selling when its price is high. But this requires spending a lot of time analyzing the market.
If you are planning to invest in stocks and bonds as a part of your portfolio, you should consider several factors. It’s recommended to focus on stocks if a person is young, but it is not the rule. Put a larger percentage of a portfolio in stocks since it offers a long-term reward if invested wisely, but combine this investment with bonds.
If you are approaching retirement, it’s a better idea to focus on bonds. Stocks can grow in price throughout the years, and still, there is a risk of losing investment. While bonds greatly reduce the short-term risks. Bonds work as insurance for a stable passive income.
Author: Charles Lutwidge