Bonds Vs. Stocks: How They Differ?
Confused between bonds and stocks? If you are looking to invest in the market, it is crucial for you to understand the different options available to you. The debt market, where bonds are traded, and the equity market, where shares are traded, provide an investor options according to their risk appetite. Read further to understand whether you should go for bonds or stocks.
What are Stocks and Bonds?
A company in need of capital issues stocks or equity to the public to collect funds. The stocks are in fact testimonials of proof, called ‘Certificates’ that an investor gets when he purchases stocks. This confirms that he owns a small part of that company. When an investor purchases stocks, he becomes a shareholder of that company and is entitled to a portion of the profit or loss that the company makes. Stocks are traded in the equity market and their ownership is transferable.
Bonds, also called debt instruments, are issued by a Company or the Government to collect funds from the public with a promise that it will return the amount to the investor after a fixed period with interest. Sometimes, it also periodically pays the investor a fixed amount of money in the form of interest at a certain rate (called coupon rate). The risk involved is minimal - even if the company does not perform well the bond holder will be paid. As compared to stocks, bonds are relatively short term and the issuer of the bond will face bankruptcy if the bond is not honoured. The owner of the bond can sell it in the market and the ownership of the bond can be transferred.
Key Differences between Stocks and Bonds
Bonds and stocks differ fundamentally in the following ways -
Issuing Organisation: The stocks are normally issued by companies, whereas the bonds can be issued either by the Government or Companies.
Ownership: The owner of the bond is treated as a lender and is entitled to his fixed returns, whereas the owner of stock is treated as shareholder and his returns are directly dependent on the performance of the company.
Risk: The risk of the stockholder is comparatively higher than that of a bond owner, because his returns are dependent on the performance of the company. In case the company faces bankruptcy, the bond owner is paid first and the shareholder comes last.
Term Period: The stock has no shelf life and can be held till the company is active and in existence. On the other hand, the tenure of a bond is fixed at the time of purchase.
Investor: Investors who are looking for long-term lucrative gains and are ready to take risks invest in stocks. Whereas, investors who are looking for short-term fixed and secured income purchase bonds.
Additionally, the stockholder gets the right to participate in making decisions of the company whereas the bond holder only gets what he invested in purchasing the bond along with the periodic interest.
Pros and Cons of Stocks and Bonds
The biggest advantage of a bond is that they are secure and reliable - a bond holder is not only ensured of his periodical fixed interests but also the principal value of the bond. The full principal value is usually paid after completion of the full term of the bond. Bond prices fluctuate lesser as compared to stock prices. Bond prices fall as the interest rates go up – long-term bonds may suffer from price fluctuations as interest rates go up and down. Even though bonds are more secure, historically they have provided lower long-term returns as compared to stocks.
Stock prices rise and fall dramatically and are tied to the performance of the company and the market fluctuations. The investor is tied to the uncertainties in the market for the value of their investment. Yet, investors are still attracted towards stocks because of the higher chances of making profits. Some stocks also pay dividends which can cushion a drop in the share prices or be used to buy more shares. A stockholder also has the added advantage of the rights to participate in the company's decision-making. Invest in stocks if you are comfortable with long term profits and have a sizeable appetite for risk. The share market is also more liquid and selling of an investment is much easier as compared to a bond.
Which is Right for You?
Each type of investment has its own potential rewards and risks. While choosing between bonds or stocks, you need to consider if the investment is aligned with your goals and your appetite for risk. Each investor has his own set of rules for investing. If you have safe and short-term gains in mind, you may prefer to invest in bonds. If you are patient to fulfil long-term goals, you should go for stocks, especially if you can handle risks. However, it is always advisable to not put all your eggs in one basket. Diversify your portfolio by investing in a combination of stocks and bonds. If you have a much larger appetite for risk, you may consider keeping the ratio of investment in stocks higher than bonds. You can invest in stocks when you see a market trend favourable for investment and if the value of stocks is tumbling down you can wait for it to rise again. However, if your appetite for risk is low then sticking to the debt market is considerably safer.