Stocks and bonds are two of the most well-known ways you can invest your money. Often referenced together, as in “the first thing you’ll want to do is invest in stocks and bonds,” they’re actually two very different types of investment vehicles to be used in very different ways. In the following, I’ll discuss how they work and what they’re used for.
Stocks
Put simply, to buy stocks is to buy ownership in a company. Often referred to as “shares” or “equity,” stocks entitle the holder to a commensurate proportion of the issuing corporation’s assets and earnings. For example, if a company issues 10,000 shares and an investor own 250 shares, that means they own 2.5 percent of the company.
A company will “go public” and sell stock on an exchange in order to raise funds. However, the tradeoff is that they relinquish equity to the stockholders.
Types of Stocks
The two fundamental types of stocks are “common” and “preferred.” Generally, if an investor owns common stock, they are able to vote at shareholder meetings and are entitled to receive dividends. Preferred stockholders, on the other hand, usually don’t have the ability to vote. However, if someone holds preferred stock, then they have a higher claim on dividends or earnings than common stockholders. For example, if the company goes bankrupt, preferred stockholders have priority over common stockholders in the event the company is liquidated.
Bonds
Essentially, bonds are loans. When an entity, such as a corporation or government body, needs to raise money, they will issue bonds that individual investors can buy. When investors buy a bond, they are loaning the issuer money based on certain terms. So, bond owners are creditors of the issuer.
All bonds have a specific maturity date, at which time the principal of the loan, along with interest, will be paid to the bond owner by the issuer. Additionally, bonds pay interest over the life of the bond, called coupon payments. Bonds are often publicly traded but they can also be traded privately between the borrower and lender directly.
What to buy? Stocks or Bonds
Generally, investing in the stock market is riskier than buying bonds. This is because the value of stocks is based on the performance of their issuing companies. While this means the investor will benefit from a company performing well, it also means they’re liable to lose out when the company performs poorly. So, while there’s a higher potential for long-term gains with stocks, there’s also more short-term risk.
Bonds, on the other hand, are not as risky as stocks because they tend to pay back the full principal at maturity, so there is much less risk of loss. However, because bonds are limited by their interest rate (or coupon) they have a much lower income potential than stocks. Its important to remember that bonds can (and will) trade at a discount or premium based on changes in current interest rates.
The right investment strategy for you probably includes a mix of stocks and bonds, depending on your individual situation. The makeup of your portfolio will change based on your risk tolerance, goals, and age. It’s best to meet with your financial professional when deciding on your investment objectives.
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