Introduction
Stocks vs bonds: these are two tried-and-tested markets that have been around for eons, compared to forex and the more recent crypto. But what’s the difference between stocks and bonds?
Essentially, stocks represent ownership of companies, while bonds are loans made to governments and large businesses. The second key distinction is how money is made or lost. Stocks rely on a company’s price depreciation or appreciation, while bonds rely on interest.
Let’s uncover the stocks vs bonds differences in more detail here.
What are stocks?
Let’s look at the first part of our stocks vs bonds discussion. Stocks (equities or shares) are financial instruments denoting fractional ownership of a traded company. Most stocks are traded on stock exchanges (check out their trading hours here), a marketplace for businesses to issue their shares.
The purpose is for the company to raise external funding from private investors. Once they meet the requirements for being listed, they determine how much equity they will offer to shareholders.
This portion is sold as shares at a set price during an initial public offering (IPO), the first official day the underlying company is listed.
Based on several technical and economic factors, the stock will decrease and increase in value over time. This means that investors can profit by buying and selling.
Here is a candlestick chart of Tesla, one of the most popular stocks globally.
Some shares offer shareholders dividends (on top of any profits from price appreciation), a portion of the company’s profits.
Another method of trading shares is through derivatives or CFDs (contracts for differences). This means you don’t own the actual stock but still have the benefits of trading its price for profits and losses.
What are bonds?
“The name’s Bond, James Bond!” Puns aside, what is a bond? Bonds are loans offered by investors to various entities, most commonly corporations and governments. It’s a way for ordinary individuals to become lenders for large institutions in return for interest payments.
Bonds are another method of financing away from traditional banks. Governments always need money to fund infrastructure and daily operations. Similarly, a company requires cash to grow their business through hiring employees, buying equipment, investing in property, etc.
So, a bond is like a crowd-funded debt instrument allowing thousands of investors to become lenders.
The borrower or issuer (the entity needing the loan) creates a bond with details of the loan term and the frequency of interest payments. Like traditional credit, there is a maturity date where the principal plus interest should be paid to the lender.
Interest yields (known as coupon rates) worldwide range from 0.5% to 14%. The longer the loan term, the higher the rate is generally.
The most popular bond in the world is the 10-year Treasury note (US10Y) issued by the American government. It’s a bond paying fixed interest every six months for a decade.
Now, as with stocks, you don’t have to own the actual bonds. Instead, you can trade the instrument as a derivative. There are many bond markets (aside from US10Y), like the Euro Bund (EUBUND) and UK Gilt (UKGILT).
Below is an image of a chart for the US10Y yields since 1912.
Like stocks, traders can analyse these instruments using technical and fundamental analysis.
Stocks vs bonds: key differences
By now, it should be clear what the purpose of each market is. So, let’s look at the key differences between stocks and bonds investments.
- Purpose: The objective is the first obvious contrast between bonds vs stocks. A stock is an investment in a listed company. On the other hand, a bond is a loan made to corporations and government entities.
- Return type: This difference is perhaps the most significant. Returns from stocks come by way of capital gains. This means that you only make money if the price is lower than what you sold it for or higher than what you bought it for.
Meanwhile, bonds are fixed-income investments. The return is, in theory, guaranteed in the form of interest payments. It’s one reason why experts consider bonds as the safer investment.
Note: interest payments don’t apply if you’re trading a bond as a derivative or CFD.
- Risk: This is an extension of the last difference. Generally, there is more risk involved (but higher returns) with stocks, given the number of factors that can influence their prices. Bonds are the ‘safer’ options because they have predictable returns.
- Trading arena: Traditionally, the trading of most stocks happens on exchanges like the New York Stock Exchange and NASDAQ. Contrarily, many bonds are traded ‘over the counter.’ This means the trading doesn’t happen on a public platform but rather through brokers.
Note: Brokers are financial services providers offering derivatives. So you can trade stocks or bonds with them.
Benefits and drawbacks of stocks
So why would you consider stocks over bonds? (and why you may decide against it)
Pros
- Better returns: The historical performance of stocks far surpasses that of bonds. Mega corporations like Amazon, Apple, and Microsoft have annualized returns above 20%. This excludes individual yearly performances, which, in some cases, have exceeded 100%.
These are just the blue-chip shares. Other lesser-known stocks have performed way better. Meanwhile, bonds are slow-growing assets. As previously mentioned, bonds pay between 0.5% and 14% interest yearly.
The US 10-year treasury bond has averaged around 3.7% in the last few years, a far cry from stocks.
- Broader scope: There are tons of different stocks you can follow, like blue-chip, growth, dividend, defensive and penny stocks, among others. On the other hand, the selection of bonds is limited.
- More accessible: The average person will know what shares are, but less so on bonds. Also, you need to invest far more money in bonds to achieve a fraction of stock returns that you can receive with less capital.
Cons
- More risk: The most apparent downfall with equities is, of course, volatility. Although stocks have performed far better, there are many periods where they haven’t. So, this market is less stable compared to bonds.
Benefits and drawbacks of bonds
So why would you consider bonds vs stocks? (and why you may decide against it)
Pros
- Stable returns: Bonds are less volatile than stocks, meaning their performance is more reliable. If you invest in bonds (not as a CFD), your interest payments are almost guaranteed because the likelihood of default has been low historically.
Cons
- Weaker performance: Despite having better stability, the returns are measly compared to equities. Also, it’s a myth that bonds are risk-free. Aside from the rare possibility of defaulting, interest rates fluctuate. Subtle risks like inflation can lead to losses or investors making less money than expected.
- Less accessible: Unless you’re trading the bond as a derivative, you need more funds to invest in bonds than stocks. Also, bonds are less popular, making them harder for the average person to understand.
Conclusion
When looking at stocks vs bonds, it’s quite telling that the bond market is technically larger in value than the equities market. After all, debt is what fuels most economies. Yet, despite this fact, stocks have more benefits.
Like bonds, experts have long considered shares among the best long-term investments. The only difference is the performance is far superior. This is because they increase as companies become more valuable, boosting their bottom line.
On the other hand, bonds are not income-generating assets but simply interest payments. Still, many investors choose bonds to achieve better returns than they would from a savings account. Also, it is common for them to invest in stocks simultaneously.
Here, they have the potential to achieve multi-bagger returns while making ‘slow money’ from bonds; double impact, if you will!
