Bonds vs Stocks – which are their similarities and differences? One of the most common questions investors ask their financial advisor is “what are the differences between bonds and stocks?”. Understanding the difference between a stock and bond is a good first step when making a decision about where to invest.
The Difference Between Bonds and Stocks
- Stocks can only be issued by a corporation via stock brokers. Bonds can be issued by either corporations or government entities. For example, as a city Los Angeles can issue a bond to raise money but they cannot sell shares of stock. However, as a corporation Microsoft can sell shares of stock and they can also raise funds via bonds.
- Stocks may pay 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 than bonds.
- In the case of bankruptcy, bonds generally provide more safety than stocks.
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 important 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 trading 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 – What Happens if 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… Bonds or Stocks?
As mentioned at the beginning 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 assets. This means more of 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.