Stocks vs Bonds: Which Is the Better Investment?

October 20, 2020 | Joyce Ibrahim

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Whether or not you’ve already begun building your investing portfolio, you’ve inevitably heard of stocks and bonds. Stocks and bonds are both deeply rooted in the capital market’s history, and although they’re often paired together, each presents their own range of characteristics and variations. To better understand which type of securities is more suitable for you, it’s important to look into the differences between the two asset classes, and the risks and rewards they present.   

 

What are stocks 

From an investing standpoint, stock represents partial ownership in a company. This means that when you buy one or more “shares”, you’re really purchasing a small fraction of the company. In other terms, when you become a shareholder, you become entitled to a portion of this company’s earnings proportionally to the number of shares you bought.  

 

Stocks, also known as corporate stock, common stock, corporate shares, equity shares, and equity securities are most commonly issued to the public by companies that want to raise cash for future growth.  

Let’s say that a company looking to raise its operating capital is offering stock at $100 the share, and you invest $3000, or the equivalent of 30 shares. Over the years, the company you invested in performed consistently well, and its stock price increased by 50%, reaching $150. As a result, the value of your shares will also increase by 50% to reach $4500, which you could then resell at a $1500 profit.  

 

Since you’re a partial owner of that company, its success is also your own. But the opposite is equally true. Should the company perform poorly, the shares you bought could fall below their initial value, causing you to lose money if you decide to sell them.   

 

What are bonds 

Bonds, much like stocks, are usually issued when an entity is looking to raise funds. However, bonds more accurately function as a loan from an investor to a borrower, typically a company or a governmental entity. When you buy a bond, the company or government at hand will pay you interest on the loan for a set term, after which it will pay back the full amount (principal) you bought the bond for.  

 

If you buy a bond for $2,500 at an annual interest of 2% for 10 years, you would receive $50 in interest payments every year, usually distributed evenly over the year. After 10 years from purchasing the bond, you would have earned $500 in interest, and you’d be entitled to your initial investment of $2,500 if you hold your bond until maturity.  

 

Because the regular interest payments serve as a source of predictable fixed income over long periods, bonds can be considered as a more conservative investment. However, they don’t come without their own set of risks. For example, should the issuing company or institution go bankrupt during the bond period, you would likely stop receiving interest payments, and may not retrieve your full principal.  

 

Different risks, different rewards  

While both asset classes are instruments to grow your wealth, they widely differ in the risks they entail and the rewards they offer.  

 

Perhaps the biggest advantage stocks offer over bonds is that they tend to earn investors more money, especially over the long term. According to CNN Money, large stocks have returned an average of 10% a year since 1926, whereas long-term government bonds returns ranged between 5% and 6%. Moreover, stocks offer better returns if a company grows exponentially. Investors could then potentially earn millions of dollars on a small initial investment. For those willing to take the risk, stocks can pay out more than bonds in returns as the company’s stock could continue rising if it is performing well. 
Yet, and for countless reason, the stock market is very unpredictable, making it extremely easy to lose money by investing in the wrong stocks.  

 

In contrast with stocks, bonds come with fixed interest rates that promise a certain return. Therefore, while the value of the bond may slightly fluctuate, you are certain to receive a specific percentage yield on your initial investment. For this reason, bonds are considered as a more conservative investment, as lower risks also imply lower returns.  

 

 

These varying levels of risks and returns are crucial factors to take into consideration when building your portfolio. If you’re seeking to achieve the highest returns possible, as a general rule of thumb, equities will help you get there if you choose your stocks wisely. Nevertheless, bonds can provide the fixed income your portfolio needs to diversify from stock and preserve capital.  

In a nutshell, it’s important for you to align your risk appetite to your risk tolerance, and assess what you’re really trying to achieve with your portfolio before allocating asset classes.  

 

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