Bonds vs Stocks – Which Investment is Better for You? One of the most important questions investors ask financial advisors is “should I invest my money in bonds or stocks?”. For most investors the answer is probably a mix of both stocks and bonds but that’s not always the case. Understanding the difference between a stock and bond is a good first step when making a decision about where to invest.
Here’s a quick review of the differences between bonds and stocks:
- Stocks can only be issued by a corporation. Bonds can be issued by either corporations or government entities. For example, the city of Los Angeles can issue a bond to raise funds but they cannot sell shares of stock. However, Microsoft Corporation can sell shares of stock and they can also raise funds via bonds.
- Stocks may pay investors dividends which are not guaranteed. Bonds pay interest which is guaranteed, unless the company or government entity goes bankrupt. For this reason, stocks are generally considered to be riskier investments than bonds.
- In the case of bankruptcy, bonds generally provide more safety than stocks. If you’re just starting out it would be a good idea for you to read up on Investment Safety Basics.
Bonds vs Stocks: Lender vs. Shareholder
When you buy shares of a stock, what you are actually purchasing is a small piece (or a large piece if you are someone like Warren Buffet!) of ownership in a company. Since you have become a quasi-partner/owner you gain some special privileges, including the right to vote on issues that could affect the future of the company. More importantly however, is this: As a stockholder you will share in the profits of the business, when and if those profits are paid out in the form of dividends.
Just as a company can raise money by issuing and allowing people to buy its stock, companies can also raise money by issuing debt in the form of a bond offering. When you buy a bond you are not getting any ownership in the company, but rather you are buying a piece of the company’s debt. As a bond holder you have zero voting rights and will not share in the profits of the company, however you do receive other advantages that you do not get when buying stock in a company.
Bonds vs Stocks – How you Make Money
One of the main reasons why the price of a stock goes up or down is the profitability, or lack thereof, of the company whose stock you own. If the company is making a lot of money in profits, then its shareholders (the people who own shares of stock in the company) often stand to make a lot of money as well. On the other hand, if the company is losing money, then its shareholders can generally expect to loose money on their investment as well. If things get so bad with the company that it can no longer pay its obligations and files for bankruptcy, stockholders are generally last in line to get their money back, and therefore often lose their entire investment. This is part of the risk of investing in stocks.
As a bondholder you will receive an interest payment at specified intervals, regardless of how the company is doing (as long as the company does not go bankrupt). While the price of a company’s stock shares can (and often is) affected by any piece of positive or negative news from the company or the economy, as long as the company is earning enough money to pay its debt obligations, they are legally required to do so. This means that, good or bad, as long as the company does not file for bankruptcy, you get your interest and principal payments. The downside here of course is that if the company has a great year from a profits standpoint, you will not earn any additional interest either. As you can see, the risk-reward principle is clearly honored in the case of stocks vs bonds.
Bonds vs Stocks – When a company goes bankrupt
Another key difference between a bond and a stock is what happens when a company files for bankruptcy. As discussed above, stock holders are last in line in this situation. With this in mind, another advantage of owning a bond over a stock is that generally bond holders are the first people in line to get whatever money is left and/or which can be generated by the sale of the company’s assets. Only after all the bond holders and other creditors are paid, will stock holders get any of their money back. More times than not, in the case of bankruptcy, there is not enough money to make the bond holders and other creditors whole, so stock holders end up with nothing.
So… Should you Invest in Bonds vs Stocks?
As mentioned at the top of this article, the answer is usually a combination of both stocks and bonds. How you or your financial advisor divide between the two will depend on several factors including your risk tolerance and your age. Generally, as you become older and as you become more dependent on savings and investments to fund your life, you will move further toward less risky investments. This means more of your investment portfolio will be focused on investments like bonds. They may pay you less than a stock, but since they pose less risk they are are usually preferable later in life.
If you have additional questions regarding bonds vs stocks we recommend you contact your financial advisor. You can also leave questions in the comment field below.