Bonds and Stocks are two most popular terms used in Wall Street. If you are planning to invest for the first time in the market and are not sure about the meanings and differences of these terms, you are in luck. As today, we will be diving deep into these two instruments of corporate finance.
By the end of this article, you would have complete and detailed information about the definition of stocks and bonds and would be able to answer the key question: What is the difference between stocks and bonds?
Bonds Vs. Stocks
Bonds are basically debt instruments, and stocks are the representation of Ownership in the stake of a company. Any type of investment has one basic rule of thumb, it is, “higher the risk, higher the return.”
Keep in mind, though, in a perfect world only would you be able to gather proportionate returns every time you invest in risky instruments. The reason for this uncertainty is the nature of the market that is filled with risk.
Sticking to the topic in hand, bonds are relatively less risky as the investors’ income in bond holdings is fixed to a certain rate on the principal amount that is agreed upon on the date of investment only. At the end of the debt period, i.e., on the maturity date, the principal amount is repaid as well.
On the other hand, stocks are stakes in Ownership of a company. As you become the owner of a company, you will have to bear the risk of running a company and enjoy future returns.
The income of stockholders is mostly from the value appreciation of their stock holdings and occasional dividends that are distributed at the discretion of the company from its profits.
Keep in mind, a company is under no obligation to pay these dividends even after a successful financial year. This makes it clear that if you are a passive investor and are not looking to take heavy risks for their investments, Bonds are perfect for you. The opposite is true for stocks.
Moreover, stocks and bonds are both sold in a different manner. The most popular marketplace for buying securities is the stock market. Only stocks are sold internationally using separate stock exchanges.
In the US, premier stock exchanges include the New York Stock Exchange (NYSE), Nasdaq, or the American Stock Exchange (AMEX).
These stock markets are home to major and frequent transactions almost daily and are aggressively monitored and regulated by a constitution backed regulator, which is the Securities and Exchange Commission (SEC) in the US.
On the other hand, you would not be able to buy bonds as easily or conveniently as stocks. Unlike stocks, they are not actively traded in central dedicated exchanges but are usually sold over the counter (OTC).
In a nutshell, Bonds are more secure as the periodic interest payment is fixed along with the repayment of the originally invested amount at the maturity date.
They are not susceptible to market fluctuations. On the other hand, stocks are more susceptible to risk as nothing is fixed in its regards.
However, as per the basic rule of thumb, the overall return potential is much higher in them if you are willing to undertake the adjoining uncertainty.
What Is A Stock?
Stocks, also called shares or equity, are a stake of Ownership of a publically listed company that can be purchased electronically from the various local and regulated stock exchanges using cash.
Not every company sells its stocks to the general public, though. You must understand there are different types of limited companies incorporated every day, and not all of them are both willing and capable of gathering funds from the public.
Most people that start a business, called promoters, invest their own personal savings in their business. They can also get funding from venture capitalists, who are willing to invest in an idea. The reason for this conservativeness is simple, Ownership.
When a company is listed, and its shares are traded publicly, the promoters are no longer the only owners of their business, which deters them from going public.
Initial Public Offering (IPO)
Regardless, companies that wish to expand their business can always get themselves listed and offer the public a prospectus containing all the information deemed by the regulator to be necessary about the company.
After the issuance of the prospectus, the company receives share applications for allotment of their shares in its Initial Public Offerings. Investors are always able to assess the ongoing performance of their invested companies through mandatory quarterly statements and Annual reports.
If the investors project that the company would not perform well in the future and the stock could tumble, they can easily sell the stocks of that company and invest in some other promising company.
Company’s shareholders are the owners of the company. It means that they would hold rights and obligations to the company’s proportionate asset and liabilities.
It is a collective decision of the company’s members as to what to do with the company’s revenues. They can distribute dividends or reinvestment them as per their will.
What Is A Bond?
Unlike stocks, bonds are similar to any other borrowing instrument for the company. They do not have a stake of Ownership or a right to the company’s assets. They are simply third party creditors for the companies that have to be repaid a fixed sum that is agreed on the date of investment.
Due to the lack of ambiguity, Bonds much safer than stocks. Be it stocks or bonds, such finance instruments are subject to various macroeconomic risks, including inflation.
Low Risk but Caution Required
However, just like other fixed income instruments, bonds are susceptible to more risk due to inflation. To understand this better, just notice that a 100$ tucked underneath the mattress would be able to buy fewer bananas than now after three years.
Regardless of the instrument we are addressing, stocks, or bonds, there will always be a degree of risk involved.
Comparatively, bonds are less risky, but they are susceptible to credit risk. Credit Risk is the risk of default by the borrower in paying or repaying the dues. So, it is recommended that, in order to minimize the credit risk, you must always check the ratings of these bonds.
Companies, as well as the government issues bonds. It is obvious that companies are more likely to default in payments than the Government, so they offer a higher interest rate.
Stocks and bonds are both instruments of corporate finance and pose as good investment opportunities to get high returns. Most people’s first question is – what is the difference between stocks and bonds?
In this article, we have explained the key difference between stocks and bonds, along with the definition of stocks and bonds.
It is not often advisable to hold 100% of any one of the instruments, stocks, or bonds, in your portfolio. Diversification is key. We will discuss more the composition of the portfolio in future articles.
We hope this article was insightful for you. Do share your thoughts and ask any queries using the comments section down below.