When you buy a stock, you have a stake in that company. You are an owner. When you buy a bond, you loan money to the company. You are a creditor. This article explains the primary differences between stocks and bonds and what that means for you as an investor.
What Distinguishes Stocks from Bonds
Stocks and bonds are different asset classes. They have different financial attributes and react differently to various economic and market inputs. The distinguishing characteristics of stocks and bonds can be explained in three ways:
- The rights they offer
- The returns they generate
- The risks they present
The Rights Stocks and Bonds Offer Investors
As a stockholder, you have a right to information and have a say in company operations. Public companies must report the results of their operations to you and you have the right to elect company directors and to vote on important corporate matters.
Stock ownership also entitles you to receive dividends when they are paid. You have a similar right when you own a bond.
When you own a bond, you are entitled to regular interest payments until the bond matures or is called (bought back early). You are also entitled to the return of your money at the maturity or call date.
Bondholders are not owners. You can’t vote for directors or on company business issues. Your rights are typically limited to interest payments, getting your money back when the bond matures and a claim on certain assets if the bond goes into default.
The Returns Generated by Stocks and Bonds
A key differentiator between stocks and bonds is investment return.
People invest in common stocks for potential capital appreciation. What makes bonds attractive is the cash flow they provide through interest payments. So, you might own stocks to grow your money and you might own bonds to earn income.
Some companies may return their excess cash from operations to stockholders in the form of dividends. So, you could also own a stock for the income it generates. But generally, investors buy stocks to help build wealth.
Bonds don’t offer the same capital appreciation potential as common stocks. Bondholders are paid interest. But a bond may appreciate in value under certain conditions.
Selling a bond for more than its original cost will create a profit. In that sense, bonds could potentially help build wealth. But those opportunities are more limited than they are with common stocks.
The Risks Stocks and Bonds Present to Investors
All investments carry a certain degree of risk.1 Risk is part of investing.
Investing in a business, whether as a shareholder or lender, exposes you to all of the risks inherent in that business. Those risks are unavoidable for either stock or bond investors.
Also common to both stocks and bonds is price risk, or volatility. Stock and bond prices fluctuate regularly. If the market price of a stock or bond you own drops and you sell it for less than you paid for it, you will incur a loss of principal.
Historically, stock prices have been more volatile than bond prices, and therefore present a greater risk of capital loss than bonds. But bond prices have been more susceptible to rising interest rates. When rates go up, bond prices go down.
Bonds have an additional long-term risk that stocks seem to avoid. Inflation presents a greater risk to bonds than to common stocks. While stocks may increase in value over time, the face value of a bond will not.
The funds you receive at maturity won’t be inflation adjusted. So, the purchasing power of those dollars could be lower than what you originally invested.
Fortunately, each of the risks in stocks and bonds can be managed. Techniques like asset allocation and diversification can mitigate overall portfolio risk. Employing these risk management tools may help you benefit from the growth and income opportunities stocks and bonds offer.
Working with experienced financial professionals can help you stay the course. They can provide guidance and encouragement to help focus your attention on your long-term goals.
1 All investments carry a certain degree of risk, including the possible loss of principal, and an investment should only be made with an understanding of the risks involved with owning a particular security or asset class. Investors are strongly encouraged to seek advice regarding the best options for their particular circumstances from qualified tax and financial experts.
