Comparing investments: the difference between stocks and bonds
Lots of people wonder if it’s better to own stocks or bonds (directly or through mutual funds). The answer is that it depends. But what it depends on is a tad complicated. A big part of achieving your investment objectives (i.e., having enough money to buy the stuff you want and need) is determined by the types of assets in your portfolio. That’s because different investments behave in different ways. They have different types of risks and deliver different types of returns.
So, before you make any investment decisions you should figure out what you’re trying to accomplish. It also helps to understand which type of investment is more likely to help you achieve that goal.
The Distinguishing Characteristics of Stocks and Bonds
If you think there’s some equivalency between stocks to bonds, think again. They are different asset classes. An asset class is a group of investments that exhibit similar characteristics and offer the same type of return.
And just to be very clear, stocks and bonds don’t have similar characteristics or offer the same type of return. And they don’t behave the same way. That’s because of what each represents.
A stock represents an ownership interest in a company. A bond represents a debt of a company. Stock investors are owners. Bond investors are lenders. This is why stocks and bonds don’t behave the same way.
What Investors Get for the Money
Investors who buy stock have a stake in a company’s earnings and assets. If the company is successful and increases its revenue and profit over time, its stockholders will typically see the value of their investments rise accordingly.
However, if the company falls victim to fierce competition or poor management decisions, it’s revenue and earnings could shrink. If that happens, the value of those shareholders’ investments could decline. That’s part of the risk of owning stock.[i] Bonds offer something different.
Bonds investors loan money to a company. They are not owners. So, they have no interest in earnings and assets. But they do have a claim to them. If a company fails, bond owners can look to its assets to settle their debt. But this doesn’t happen very often.
Most companies that sell bonds to investors are healthy and meet their obligations. That means their creditors (bondholders) generally get their money back at maturity. In the meantime, bond investors get paid a set rate of interest, typically every six months.
Defining Investment Return
The other distinguishing characteristic between stocks and bonds is how investment return is defined.
The primary return common stocks offer is capital appreciation. Still, it is possible for common stocks to also provide income. Companies that generate excess cash from operations, sometimes return it to shareholders. Those payouts are called dividends.
So, common stocks can deliver two types of return: capital appreciation and dividend income. But the more common reason people invest in stocks is for their ability to grow in value. Common stocks can help investors build wealth.
Bondholders are not entitled to the type of capital appreciation that comes with owning stocks over long holding periods. The return bondholders receive is interest income. So, typically people invest in bonds for the cash flow.
Match Investment Returns to Financial Objectives
So, back to the beginning. Which is the more appropriate investment, stocks or bonds? That all depends on what an investor’s financial objectives are.
Different asset classes (like stocks or bonds) produce different types of investment returns.
Understanding which type of investment is more likely to accomplish a given goal (e.g., building wealth, generating income, preserving capital) may help an investor align available investments options with specific financial objectives.
Our Representatives are available to answers questions about the differences between stocks and bonds. They’re available Monday-Friday 7:30am to 8:00pm (CT) at (800) 235-8396.
1 These are just examples. There are many reasons for stock prices to fluctuate over time. Some are directly related to a company’s performance. Some are related to other, seemingly unrelated influences. And if a company fails (goes bankrupt), common shareholders have no security claim against company assets.