Stocks vs. Bonds

Stocks and bonds are the two main classes of assets investors use in their portfolios. Stocks offer an ownership stake in a company, while bonds are akin to loans made to a company (a corporate bond) or other organization (like the U.S. Treasury). In general, stocks are considered riskier and more volatile than bonds. However, there are many different kinds of stocks and bonds, with varying levels of volatility, risk and return.

This comparison offers a basic overview of these asset classes and considerations for incorporating them in a diversified portfolio.

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Bond

Stock

Kind of Instrument Debt Equity
Meaning In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest In financial markets, stock capital raised by a corporation or joint-stock company through the issuance and distribution of shares
Centralization Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system Stock or share markets, have a centralized exchange or trading system
Holders Bond holders are in essence lenders to the issuer The stock holders own a part of the issuing company (have an equity stake)
Kind Securities Securities
Yield Analysis Nominal yield, Current yield, Yield to maturity, Yield curve, Bond duration, Bond convexity Gordon model, Dividend yield, Income per share, Book value, Earnings yield, Beta coefficient
Participants Investors, Speculators, Institutional Investors Market maker, Floor trader, Floor broker
Issued By Bonds are issued by public sectorauthorities, credit institutions, companies and supranational institutions Stock are issued by corporation or joint-stock companies
Owners bondholders stockholders/shareholders
Derivatives Bond option, Credit derivative, Credit default swap, Collateralized debt obligation, Collateralized mortgage obligation Credit derivative, Hybrid security, Options, Futures, Forwards, Swaps
No. of Types 12 Types 4 Types

Contents: Stocks vs. Bonds

edit What Are Stocks?

Stocks, or shares, are units of equity — or ownership stake — in a company. The value of a company is the total value of all outstanding stock of the company. The price of a share is simply the value of the company — also called market capitalization, or market cap — divided by the number of shares outstanding.

Stocks of a company are offered at the time of an IPO (Initial Public Offering) or later equity sales. Stocks are usually traded on exchanges like the NASDAQ and the New York Stock Exchange, which offer great liquidity (i.e., the ability to convert investments into cash as soon as one needs to).

edit What Are Bonds?

Bonds are simply loans made to an organization. They are a form of debt and appear as liabilities in the organization's balance sheet. While stocks are usually offered only in for-profit corporations, any organization can issue bonds. Indeed, the governments of United States and Japan are among the largest issuers of bonds. Bonds are also traded on exchanges but often have a lower volume of transactions than stocks.

edit Types of Stocks and Bonds

There are many different kinds of stocks and bonds to choose from, some of which make for more sound investments than others.

edit Types of Stocks

Stocks fall under two main categories, common stock and preferred stock, and preferred stock is further divided into non-participating and participating stock. The vast majority of investors only buy and sell common stock. Under it, it is easiest to think of stock types according to several primary factors. Good, diversified portfolios include a variety of different types of companies' stocks.

edit Types of Bonds

The bond market, which is also sometimes known as the debt or credit market, allows investors to issue new debt in what is known as the primary market and buy and sell debt securities in the secondary market.

edit Stocks and Bonds to Avoid

edit How Are Stocks and Bonds Valued?

The price of a stock is determined by what buyers and sellers on the exchange are willing to pay/accept on any given day. In general, the value of a company is determined by the value of its assets (minus liabilities), along with the net present value of all future earnings. A key factor in determining value is the expectation of growth. If investors expect a company to grow very fast in the future, they may value the company highly even if it is currently a loss-making enterprise. Companies like Twitter and Amazon are examples of cases where the current earnings may be small — or even negative, i.e., losses — but the value of the company's assets (such as intellectual property, its customer base, brand, goodwill, and other intangibles) and the expectation of future growth is so high that the company is valued at billions of dollars.

Every investor has her own opinion of the value of the company. Share price reflects a sort of consensus opinion of the market.

With bonds, prices are determined based on how ratings companies, like S&P and Fitch, rate the creditworthiness of the issuer of the bond. For example, a corporate bond issued by Apple is rated AAA, which means the ratings agency has very high confidence in the ability of Apple to repay its loan, the bond debt that the bondholders own. The likelihood that Apple will default on its loans is very low, so the company can borrow at very low interest rates (say, 2%).

edit Bond Yields vs. Prices

A confusing element of bonds is that they have two types of valuations, a daily value, price, on the bond market, where bonds can be bought and sold, and a long-term return value, yield (or, more often, yield to maturity), where investors earn back the principal cost of the bond, plus interest, plus/minus any gains or losses.

Bond prices have a unique relationship with bond yields. Specifically, when the price of a bond goes up on the bond market, the yield of that bond decreases; or when a price decreases, a yield increases. For more vigilant and active investors, both concepts are useful. To see an example of how prices and yields relate to one another, watch the video below.

edit External Factors

Factors external to the organization also affect the price of its shares and bonds. For example, when the economy is weak and stagnating, all share prices tend to fall because the expected value of future earnings is lower. Conversely, when the economy is growing, and unemployment is low, investors are more confident.

Another factor is money supply. When interest rates are lowered — like, the Federal Reserve did in the aftermath of the 2008 financial crisis — two things happen that inflate share prices:

  1. There is more money in the financial system. More money in circulation increases inflation and fuels a rise in share prices.
  2. "Safer" options to invest money in debt (bonds) become less lucrative when interest rates fall. So investors choose stocks to chase higher returns.

edit Building a Portfolio

edit Risk and Performance

In general, stocks are considered riskier stocks are considered much riskier than bonds. However, stocks are also believed to offer a higher return compared with bonds.

It is important to understand that stocks are often very long-term investments (10+ years), usually for retirement purposes. In any given year, a stock can have steep highs and deep lows as its value is redefined again and again on the market, making frequent buying and selling extremely risky and mostly inadvisable. Over time, though, stocks tend to return 6-7% annually, on average, after adjusting for inflation and dividends.[2][3]

Graphs showing the NASDAQ, Dow Jones, and S&P 500 stock indexes over time. Notice the ups and downs but general trend toward growth.
Graphs showing the NASDAQ, Dow Jones, and S&P 500 stock indexes over time. Notice the ups and downs but general trend toward growth.

Bonds are also used for retirement savings, but shorter-termed bonds — those which mature within 10 years or fewer — can just as easily be used throughout a lifetime for small, periodic returns. Long-term (e.g., 30-year) U.S. Treasury bonds usually have a return of around 3-4%.[4]

edit Allocation

First-time investors often want to know how much money they should allocate to stocks and how much they should allocate to bonds. The answer is it depends. What it depends on is risk tolerance, which changes with age; ability and know-how when it comes to risk-taking strategies; and how much liquidity is needed. There are numerous strategies one can use to invest:

edit Diversifying Stock and Bond Portfolios

Diversification reduces risk.[5] Those who decide to invest manually in the stock market, rather than use index funds, must learn to diversify their portfolios themselves. Just because an investor is interested in or knows a lot about the energy industry does not mean he or she should only invest in it. A person who only owns stock in one company or industry is at much greater risk of losing money than a person who invests in multiple companies and industries and different kinds of bonds. The investor should buy a wide variety of stocks and bonds using some of the factors listed above.

edit Investment Tools and Fees

When it comes to investing, the old adage is somewhat true: one has to have money to make money. Investing a small amount in a single company is less wise than saving up and then investing a larger amount in index funds or across several types of companies and bonds; most brokerage accounts require at least $500 to start.

First-time investors should also be prepared for fees. Brokerage accounts charge account fees and/or trading fees. Others have different business models that charge flat percentage fees.

Some common investment tools and trackers include the following:

Several other comparisons are relevant to the buying and selling of stock: Ask Price vs Bid Price, Call Option vs Put Option, Futures vs Options, Forward Contract vs Futures Contract, Limit Order vs Stop Order, and Naked Short Selling vs Short Selling.

edit Shareholders vs. Bondholders

Shareholders have different investment rights from bondholders. As part owners of a company, shareholders get a say in how a company is run, while bondholders, as lenders, have no say in how governments or corporations manage themselves or their loan. In the case of a company liquidating, however, bondholders come out on top, with their investment receiving priority over shareholders' investments.[6]

edit Voting Rights

A benefit of owning stock is the ability to participate in companies' affairs. Shareholders have the right to look at a company's records, attend (or listen to) annual meetings about company performance, receive a cut of all declared dividends, participate in electing directors to the board, and sue the corporation for any infringing behavior.[7] There is really no eqvuivalent set of rights for bondholders.

Those with a large stake in a company will often take advantage of their rights as shareholders to help guide a company toward (hopefully) more growth. For example, voting rights are especially important, as a company's board of directors greatly affects how well a company will perform in the future.

edit Liquidation and Bankruptcy

Sometimes companies fail and have to close down or reorganize. When this happens, they may begin a process of liquidation — that is, selling assets to pay off debts — which is part of Chapter 7 bankruptcy in the U.S. Debts are always paid off first, meaning bondholders have an advantage over shareholders when it comes to liquidation. Shareholders receive any money that is left over from debt repayment, which may not be any at all. This is one of the biggest reasons bond investments are safer than stock investments.

Different types of bankruptcy, such as Chapter 11, affect bondholders and shareholders in different ways than the above, but generally bondholders come out on top when compared to shareholders. Neither are very likely to get back all of their investment, however, which proves yet again the importance of careful investment.

edit How Stocks and Bonds Are Taxed

Different types of stocks and bonds are taxed differently. In some cases, even, one state may tax interest than another does not. Sometimes federal taxes apply, and other times they do not.

In general, though, the following is true for bond taxation:

And what follows here is generally true for stock taxation:

edit References

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"Stocks vs. Bonds." Diffen.com. Diffen LLC, n.d. Web. 22 Oct 2014. < http://www.diffen.com/difference/Bond_vs_Stock >

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Comments: Bond vs Stock

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Anonymous comments (4)

September 10, 2009, 5:24am

After reading this, i clearly understood the differences. Moreover, this is very user friendly and easy to view. :)
Thanks.

— 122.✗.✗.98
1

January 21, 2014, 11:43pm

Super

— 119.✗.✗.95
0

December 31, 2013, 4:05pm

How do I go about investing

— 66.✗.✗.23
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June 19, 2013, 9:45am

its very clear to understand

— 59.✗.✗.102
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share

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