Stocks and bonds are two of the most common investment vehicles, however, there are significant differences between stocks vs bonds. They are both viable forms of investment. But what is the difference between the two? Which one is riskier? Which is better for me? This article is aimed at clarifying the differences between stocks and bonds, and explaining how each of them works.
What is a bond?
To put it simply a bond is a loan. Companies have different ways of raising capital for different needs. They can issue bonds, ask for loans or issue equity shares. When you buy a bond you essentially loan money to a specific company, organization, or government, in the case of treasuries. In the case of the government, they can raise money by raising taxes or issuing treasuries also known as government bonds.
Investors loan their money with the promise to receive interest payments on their principal until maturity. The interest paid on bonds is commonly referred to as a coupon. Coupons will be paid until maturity when the principal returns to investors. Bonds offer a wide option of maturities. There are 30-year bonds and short-term securities under 6 months. Once a bond reaches a maturity date, the investors receive their principals back.
Bonds are traded in markets just as stocks. Fluctuations in their prices will often be affected by company results. As for countries, the economic data will often have the biggest impact on the price of their bonds. Interest rates are also highly correlated to bond prices. Depending on the general interest rate of the economy, a bond price will vary accordingly.
Bonds are issued with a face value/par value. They are often issued at a certain price, and they pay a fixed coupon rate. But given the fluctuations in the market, the price may go down or up. The coupon which is fixed moves inversely to the bond price. Each time the bond price goes down, the coupon paid will be higher.
The face value, often referred to as par value represents the amount of principal the issuer of the bond will pay back to the bondholder. Since bonds are issued at a certain price, and with a fixed payment. It becomes easy to compare them historically using their issuing price as a comparison. Bonds are sold along with stocks on the open market.
But they are very different from each other. As a bondholder, you will not benefit from any improvement in the stock performance. You’re simply loaning money in exchange for a fixed interest payment. That is why bonds can often be referred to as fixed income. No matter how great or awful the company’s results are, you will be paid your coupon rate. This is one of the reasons bonds usually carry less risk than stocks.
It’s fascinating how being a bondholder has many similarities to being a bank. Banks face different risks due to their intricate operations. But their number one risk is loss of principal. If customers stop paying their loans and default on the debt. Bank’s are in trouble. The same thing happens with bondholders.
When you purchase a bond, your biggest risk is not being able to recover your principal. Despite the risk, you should conduct a careful and deep analysis before buying. Understanding the country or organization you are loaning money to, is essential to determine if they will pay you back. Having a good assessment of the financial numbers behind the institution is a great way to prevent risk when buying bonds.
Risk in bonds vs stocks
The risk in bonds varies according to the creditworthiness of the institution issuing the bonds. Government bonds usually offer the least risk. As it is highly unlikely that a country would default on its debt. Government bonds are usually considered risk-free assets. Given the unlikeliness of bondholders losing their principal.
Some companies are well established, and their financial history is more consistent. Also, offer bonds with very little risk. Stocks deemed blue-chip are usually seen as reliable, consistent, and with an excellent reputation. These companies, often larger in size and in market cap, offer more security to their bondholders. Given their long history, and long track record that spans over many years, they offer little risk. One thing common with both is that the coupon rate tends to be lower.
In essence, the coupon rate reflects the risk of the bond. The higher the coupon rate the higher the risk of losing principal. That is why investors are willing to either receive a lower rate, opting for more safety. Or they can earn a higher rate, which is also riskier. Institutions with lower credit ratings will in turn have to pay a higher coupon rate.
In order to attract investors to buy their bonds. Rating agencies will often define the credit rating of different institutions. From companies to countries, rating agencies will evaluate the numbers behind each bond offering. Calculating risk associated with the specific investment. Companies and countries are then rated, according to their ability to pay back the principal.
Comparing stocks vs bonds
By comparing bonds and stocks, we can see the correlation between risk and return. Bonds carry less risk in general and have lower expected returns. As for stocks despite being riskier, they also offer the biggest upside potential. Some investors advocate for portfolio allocation, which is a mix between stocks and bonds. One of the most popular is the 50/50 stocks and bonds. Meaning an investor’s portfolio should have half of it in bonds and the other half in stocks. This will reduce market risk, but can also dampen your returns.
Others advocate for the age rule. Meaning that the percentage in bonds should be proportional to our age. It is based on the idea that as you grow older you should prefer assets that carry less risk. Investors are willing to invest in riskier assets, as long as the expected returns are higher. But as we grow older we tend to prefer safer assets, with very little risk.
Risk differences of stocks vs bonds
Another reason why bonds are deemed safer than stocks is when things turn really sour. If a company goes bankrupt, bondholders are the first to be assured compensation. Bondholders are preferential creditors, and in the event of a bankruptcy, they will receive compensation before stockholders.
It is important for you to understand your risk appetite, and which investments work better for you. You could earn a small coupon rate nearly risk-free. Or you can aim for higher rates and the risk that comes with it. Remember the trade-off between higher rates and lower rates. Is also present when choosing between stocks or bonds as we will see.
What is a stock?
Have you ever wondered how you can invest in a company? Through stocks, you can own a part of a business. Stocks represent shares of a company. By buying shares, you essentially buy part of the ownership of the company. The stake you have in the company is determined by the number of shares you own. They are not lottery tickets as Peter Lynch once said!
Stocks come in different categories and in different sectors. They can be compared in a multitude of ways. One of the main ways to compare stocks is by the size of the company. Market Capitalization is the total amount of shares times the price per share. Allows you to understand how the company is valued as a whole. As we have seen with the difference in risk between bonds. Stocks also have different risks associated.
A smaller company is usually referred to as small-cap, meaning small capitalization. Will often have a higher risk associated. Medium-sized companies are usually referred to as mid-caps. And larger, more stable, and less risky companies are referred to as large-caps.
Smaller stocks will often have higher volatility, given that the companies are smaller and growth prospects are more unpredictable. On the contrary, a more stable and larger company will offer safety but at the same time, lower expected returns. The stock price of large caps is usually more stable.
Risk in stocks vs bonds
Stocks have higher volatility than bonds. Given their higher degree of risk, stocks fluctuate a lot more than bonds. While at the same the company’s performance is directly correlated with the stock price. The same does not happen with bonds. If the company’s prospects remain positive, the stock will appreciate at price. If for any reason those future estimates are not met and the company’s operations deteriorate. The stock price will eventually tumble.
When investing in stocks another risk to consider is market turmoil. No matter how well constructed your stock portfolio may be. There is always a systemic risk like a crash. Markets are often unpredictable and market timing is extremely difficult. Given that portfolio stocks may experience a loss sparked by a market crash.
Stocks are in essence bonds with a fluctuating coupon. When you buy stock of a company, you are essentially expecting earnings for the investment time frame. In theory, you need to analyze stocks so that you can predict the coupon the stock will pay. Despite carrying more risk than bonds, stocks are ultimately the best performing asset of the two. By using a value investment approach you can find cheap stocks. By buying a portfolio of those, you can expect to make a much higher return than buying bonds. While at the same time offering a low amount of risk.
As an investor, you should be aware of the risks associated with each investment vehicle. Being aware of the risk and taking the right precautionary measures to control and reduce it is key to being successful in the markets. With that in mind, you should research every investment opportunity thoroughly. This will ensure you make the most informed decision possible. Have a well-defined investment strategy, that will make sure you easily manage the ups and downs. It is also important to have people you can trust, that you can turn to for guidance and advice.
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