Both stocks and bonds are two of the most common routes to investing. They each have their sets of pros and cons or advantages and differences. What exactly is the difference between the two? Should you buy stocks instead of bonds or are bonds better than stocks? Understanding the distinguishing characteristics of these two is fundamental for first-time investments and in building and maintaining a sound investment portfolio.
Difference Between Stocks and Bonds
• Characteristics: Stocks are a form of security that represent proportionate ownership stakes in publicly-traded companies. Bonds are another form of security that represent loans provided by investors or debtholders to borrowers. Examples of borrowers are companies and government institutions.
• Earnings: An investor can earn from stocks through capital appreciation and dividends. So-called preferred stocks fall under the fixed-income securities classification because they provide investors with fixed dividends. Bonds are fixed-income securities that provide fixed and scheduled payouts in the form of interest.
• Risks: Each has its respective risks or trade-offs. The consensus is that stocks have higher risks than bonds and they are better suited for investors with aggressive risk profiles. Bonds have medium-to-high risk suited for aggressive to moderate investors. Of course, not all stocks are created the same. This is also true for bonds.
• Potential Returns: The risk-return trade-off suggests that investing in stocks has higher potential returns than bonds because they have higher risks. This has been proven by the historical performance of stock markets and related investment vehicles such as index funds. However, bonds offer more reliable albeit smaller returns.
Choosing Between Stocks and Bonds
Remember that stocks offer the highest potential for returns and wealth generation compared with bonds. The historical returns of stocks in the United States since the 1920s are around 8 percent to 10 percent. Bonds have historical returns of between 4 percent and 6 percent. These data prove that investing in stocks provides a better opportunity for outpacing inflation.
Stocks tend to outperform bonds for two reasons. First, the equity risk premium inherently allows investors to demand higher returns in exchange for taking on additional risks. Second, the prices of stocks appreciate during periods of economic growth. Returns from bonds are contained in fixed interests and the original loaned amount.
However, stocks have their disadvantages, especially when compared to the advantages of bonds. Stocks are riskier and they do not offer guaranteed returns. Bonds are more reliable. In addition, in case a company goes bankrupt, bondholders are paid first before preferred stockholders. Common stockholders are paid last.
It is still better to have both. A sound investment portfolio has a good mix of stocks and bonds. The composition of this portfolio should be designed for maximum gains and minimal risks, as well as in accordance with the risk profile of a particular investor, the allotted timeframe, as well as his or her financial or investment goals and objectives.