Although bonds and stocks are often discussed together in economic contexts, they are two different things.
A bond is a loan from the government or a company. A stock represents partial ownership in a corporation, such as McDonald's or Apple.
The main difference between bonds and stocks is how they make money. Those who own bonds receive a fixed amount of interest over time. Stocks are held for a certain period until they mature and are sold on the stock market to generate a profit.
Read on to learn more about bonds and stocks, how they compare and differ, the risks and rewards of investing in either, and which is best for you.
What's the difference between bonds and stocks?
Bonds and stocks are two of the most commonly traded assets on the market.
Bonds are loans you acquire from a company or the government. Essentially, when you purchase a bond, whoever sold it to you is now in your debt and must pay you interest installments over a predetermined period.
In many cases, the profits earned through bonds act as a supplemental form of income.
Most, if not all, bonds have a "maturity date." This is when the borrower must repay the total value of the loan, including its principal amount. Interest payments, also known as the yield, are calculated based on this value.
Based on their maturity dates, three classifications of bonds exist: short-term bonds, which are usually one to three years; medium-term bonds, which last 10 years; and long-term bonds, which mature after 30 years.
Owning stocks in a company means you have partial ownership or equity in that company. Stocks represent shares, and the more shares you purchase, the larger the slice of the company you own.
The value of those stocks depends on how well the company performs. If they are successful, you will reap a portion of those profits, and vice versa if they are less successful.
Stocks are referred to by multiple names, including corporate stock, common stock, corporate shares, and equity shares or securities.
Every so often, a company will make shares available to the general public. Typically, companies do this to raise more cash to fund their business in the future.
Neither bonds nor stocks are risk-free.
Bonds versus stocks
Again, the most significant difference between bonds and stocks is how they grow money and generate profit.
The risk involved in investing in bonds and stocks
The relationship between bonds and stocks is an inverse relationship, meaning that when bond prices rise, stock prices tend to fall, and vice versa.
While bonds issued by the U.S. government are relatively stable, corporate bonds are trickier. The risk lies in a company's likeliness to file for bankruptcy. If they do so, the bond is extremely risky. Ultimately, a company's ability to pay off its debt will reflect in your earnings.
Corporate bonds fall into two risk categories: investment grade and high yield. Investment-grade bonds require buyers to have a high credit rating. Like U.S. Treasury bonds, they have less risk but lower rewards. High-yield bonds, also called junk bonds, can be acquired with a lower credit score and have higher returns and higher risk.
Finally, bonds are susceptible to inflation and deflation, as well as to interest rates. If interest rates skyrocket, you may have to sell a bond before it reaches maturity to prevent financial loss. Otherwise, it could prove a severe blemish on your credit history.
The biggest risk associated with stocks is that their value will decrease after you buy them. Generally, stock prices are in constant fluctuation and are extremely dependent on several factors, including market trends, the prices and availability of goods and services for production, and consumer behavior.
Stocks are also vulnerable to liquidity risks, currency risks, and geopolitical risks.
Stocks with low liquidity are not easily converted into cash and are more difficult to sell. The risk of liquidity increases when investors cannot find other interested parties who want to buy their stocks quickly enough before they start to devalue.
Currency risk usually applies to stocks that are purchased overseas. When dealing with foreign money, there will always be a difference in conversion and interest rates.
Geopolitical risk also has an effect on international markets For example, political conflict can affect the supply and demand of commodities like oil, which can affect its price.
Overall, stocks are much riskier than bonds, but the returns on stocks can be far greater.
Which is right for you, bonds or stocks?
Ultimately, deciding to invest in bonds or stocks is a matter of personal preference. Specifically, an individual's risk is often the most notable determining factor in choosing between stocks and bonds. Bonds are more reliable, and you're guaranteed consistent returns. Stocks, however, can generate quite a bit of money.
Many investors choose to purchase both since it diversifies their financial portfolios.
Bonds and stocks are just two investment types that can lead to additional income. There are also retirement accounts, mutual funds, and Point Card.
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