If you are just getting started on your investment journey, one of the most crucial aspects to be aware of is the difference between stocks and bonds. Stocks and bonds are securities or financial instruments bought and sold in the financial markets. Beyond this basic similarity, the two categories of investments differ vastly from one another.
What is the difference between stocks and bonds
The most fundamental difference between stocks and bonds is the nature of the money used to purchase the instrument. In stocks, the money you invest buys you a portion of ownership in the company. In bonds, the money you use to purchase the security is essentially a loan that you offer the bond issuer.
In addition to this, when you compare stocks vs. bonds, you will find that several other differences affect the risks and returns from these instruments.
Stocks
Stocks are instruments that represent units of ownership in the issuing company. When you invest in a company’s stocks, you gain proportionate ownership in the entity. Your stock investments may give you two types of returns: dividends and/or capital gains. Dividends are a portion of a company’s profits that is paid out to shareholders.Capital gains, on the other hand, are earned if you sell the shares at a higher price than your purchase cost.
Characteristics of stocks
Stocks have the following unique characteristics:
- They offer the benefit of ownership in the issuing company.
- They may offer dividends and/or capital gains.
- They carry higher risk than other non-market-linked investments.
- The returns are not guaranteed.
Types of stocks
Depending on the rights available to investors, stocks can be one of two types:
- Common stock: These are the most common types of equity stocks available. They give investors voting rights but come last in the line of priority in case of liquidation.
- Preferred stock: Preferred stocks do not offer any voting rights but they are prioritised for dividend payouts as well as payments in case of liquidation.
Common stock classifications include:
- Income stocks:Known for consistent dividends.
- Value stocks:Often undervalued relative to their perceived intrinsic worth.
- Growth stocks:Expected to experience significant growth in earnings and revenue.
- Blue-chip stocks:Issued by well-established, financially sound companies.
- Penny stocks:Low-priced stocks typically traded in small quantities.
- Defensive stocks:Resistant to economic downturns and market volatility.
Bonds
Bonds are debt securities that act as loans offered by the investor to the issuing entity. When you invest in a bond, you do not gain any form of ownership in the entity that issued the security. Instead, you earn periodic interest on the purchase amount (which is effectively the amount lent to the issuer). Some debt instruments, like zero-coupon bonds, do not offer any interest. Instead, they are issued at a discount and redeemed at a premium.
Characteristics of bonds
Bonds have some defining features, as outlined below:
- They come with a defined investment tenure and maturity date.
- They offer guaranteed and regular interest payouts.
- The principal (i.e. the amount invested) is returned at maturity.
- They carry lower risk than equity stocks.
Types of bonds
Depending on the issuing entity, you can choose from the following types of bonds.
- Government bonds: These are issued by the central or state governments and carry little to no risk as they are backed by a sovereign guarantee.
- Corporate bonds: These bonds, issued by corporate entities, carry higher risk but may offer higher returnsthan government bonds.
- Zero-coupon bonds: Theseare debt securities that do not pay interest during their term. Instead, they are sold at a significant discount to their face value, and the difference between the purchase price and the face value represents the investor's return.
- Municipal bonds: Theseare debt securities issued by state, local, or territorial governments, or their agencies. These bonds are often used to finance public projects such as schools, roads, and bridges.
Difference between stocks and bonds
Now that you have seen the meaning and characteristics of stocks and bonds, let us examine how the two investment categories compare. The stocks vs. bonds table below shows the key differences between stocks and bonds.
Particulars | Stocks | Bonds |
Meaning | Equity instruments that offer ownership in a company | Debt instruments that act as loans made to the issuing entity |
Returns | Dividends (not guaranteed) and potential capital gains | Regular interest payments made at the coupon rate |
Risks | Generally higher, as returns depend on the market movements | Generally lower, but varies based on the creditworthiness of the issuer |
Rights of holders | Shareholders may have voting rights in the company | Bondholders have no voting rights |
Priority in case of bankruptcy | Shareholders are paid after bondholders | Bondholders receive priority in payments |
Investment tenure | Indefinite, depends on the shareholder’s investment objectives | Fixed as bonds have a predetermined maturity date |
Suitable for | Investors looking for growth through price appreciation and/or income through dividends | Investors with a lower risk appetite who seek regular, guaranteed income |
How to invest in bonds or stocks?
The exact process to invest in stocks and bonds depends on the channel of investment you choose and your preferred stockbroker’s terms and conditions. Broadly, here is how you can invest in these instruments.
To invest in stocks
- Identify your risk tolerance and assess if you are a conservative, moderate, or aggressive investor to determine the equity asset allocation in your portfolio.
- Study the market and decide which sectors you want to invest in so you can choose the top stocks in that segment.
- Conduct adequate research and perform fundamental analysis of the stocks you want to invest in.
- Open a Demat and trading account with your preferred stockbroker.
- Purchase the stocks you have shortlisted. Thereafter, you must periodically monitor your investments.
To invest in bonds:
- Understand your risk tolerance to determine how much of your portfolio must be allocated to debt instruments like bonds.
- Look into the different entities that issue bonds and assess their creditworthiness.
- Shortlist the bonds from issuers whose creditworthiness and historical returns align with your risk-reward preferences.
- Choose a stockbroker and open a Demat and trading account.
- Proceed to buy the bonds you have selected for your portfolio.
The upside-down - When debt and equity roles reverse
Certain equities can offer the stable income characteristics of fixed-income securities, while some bonds may exhibit the volatility associated with equities.
Dividends and preferred stock
Mature, profitable companies often issue dividend stocks. Rather than reinvesting earnings for growth, they distribute a portion to shareholders, known as dividends. While these companies may not experience rapid price appreciation, their consistent dividend payments can appeal to investors seeking to diversify their fixed-income portfolios. Preferred stock, a hybrid security, shares characteristics of both bonds and equities. It generally offers higher dividend yields than common stock or bonds, but carries a lower risk profile than common stock.
Selling bonds
Bonds can be sold on the secondary market, potentially resulting in capital gains if their market price rises above the purchase price. This can occur due to changes in interest rates or improvements in the issuer's credit rating.
However, pursuing high returns from riskier bonds can undermine the primary objectives of bond investing: diversification, capital preservation, and providing a buffer against equity market volatility.
Conclusion
Before you invest in either of these instruments, ensure that you understand how stocks and bonds compare. Assess the risks associated with these two options, perform the required technical or fundamental analysis, and make an informed decision that aligns with your investment goals, risk tolerance, and time horizon.
That said, regardless of whether you choose stocks or bonds (or both), you need a Demat account.
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