If you are reading this, chances are that your friends told you that money lying around idly in a safe will do you no good and should be invested instead. So, you are now looking for investment options that are worth your time and money. Needless to say, the first words that you came across must have been ‘stocks and bonds.’ But what are stocks and bonds? What is the difference between stocks and bonds? And how do stocks and bonds work?
Keep Reading to find out.
What are Stocks and Bonds?
Although the phrase money can buy happiness has been debated for years, there’s one thing that cannot be denied – everyone needs money no matter what. This also includes organizations who require money to buy resources, complete their daily operations, meet their goals and survive in the long term.
In order to fulfil the above stated goals and operational requirements companies can raise capital to fund its expenditures through different means. The first is by borrowing money (i.e., taking a loan or debt) while the second way is to sell ‘shares’ of the company (called equity). Both these methods fall under the term securities (a security is anything that can be bought or sold and has some type of claim on something or some type of economic value attached to it). In simple words, a security in the debt world is a ‘bond’ whereas a security in the equity world is a ‘stock.’
How Do Stocks Work?
Lets consider a hypothetical company called ABC. Company ABC was established a year ago, and now that it has made it through the initial start-up phase, its owners wish to expand. However, they don’t have all the financial resources required for the purpose. Therefore, company ABC decides to ask the general public to fund its operations. In return, it offers the buyers of these ‘stocks’ a share in the ownership of the company (the size of ownership depends on the amount of stock bought i.e. a percentage of the ownership).
How Do Bonds Work?
Suppose company ABC’s top management doesn’t want to share ownership with people who provide them the required money. In such a scenario, the company can choose to issue bonds and pay the investor a certain interest on the amount that he invests. For instance, if ABC issues a bond of $100 with a 5% interest, it means that the investor will receive $5 (5% of $100) each time after a particular time period has elapsed (a month, six months, a year and so on) until the bond matures (i.e. reaches the end of its specified duration). Upon maturing, the investor will be given back the full amount of his original investment.
The Difference Between Stocks and Bonds
Although both are a form of security, there are many differences between stocks and bonds.
- Bonds are a type of debt security while stocks are a type of equity.
- The return on bonds is called interest while the return on stocks is called dividend.
- The return on bonds is guaranteed but the return on stocks is only given if the company makes a profit.
- Unlike stocks, bonds do not give the investor voting rights in the company.
- Bonds do not have a centralized exchange or trading system while stocks are traded on stock exchanges.
So, Which Is Better for You?
Stocks are a more flexible investment option as they can be bought from an industry of your choice plus they can be liquidated anytime. But the downside is that stocks are riskier than bonds.
Bonds are extremely stable as they have guaranteed returns, but their downside is that their returns are usually smaller than that of stocks plus they cannot be cashed until they mature.
As they say, never put all your eggs in one basket. Therefore, a smart choice is to invest in both the securities after considering various factors such as your investment objectives, tolerance for risk and the time after which you want to reap the benefits of investing.