Bonds vs Stocks: A Complete Overview

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Bonds vs Stocks: A Complete Overview

Everyone, no matter who you are, has the goal of creating wealth when they first start investing, but there is often a roadblock to what they should invest in to create that wealth.

Real estate may feel a bit out of reach, but bonds and stocks are two of the most proven forms of wealth creation that you can invest in with little amounts of cash to begin with.

That’s why, today, we’re going to look at bonds vs stocks and give you the full rundown on what they are, how they differ, the advantages and disadvantages of both, and what you should be investing in. Follow along to find out what will suit your portfolio.

 

What Are Bonds?

Bonds are defined as a type of investment that requires you to raise money for a specific business or government purpose. You are essentially loaning that money to the business or government and in return, you’ll receive fixed interest payments, along with the initial investment back once the bond term is over.

Essentially, you buy bonds and allow a business or government to start a project, and because people will benefit from that project, you’ll not only help them make an impact, but you’ll receive more money than you first invested.

Interest payments (known as coupon payments) will be made to you either once or twice a year, up until the bond matures and you receive the full payment you made to begin with back.

Here’s a visual example of how bonds work:

A cycle of how bond repayments work. This example shows that if you lend £2000 to the government or company and the coupon rate is 5%, you will receive £100 a year until your bond matures, and you then receive your full £2000 back on top of these coupon payments.
This image assumes that you lend £2000 to a company and the coupon rate is 5%, meaning you’ll receive two payments of £50 in a year or one payment of £100. 5% of £2000 is £100 for reference. This is just an example and not all bonds will be like this.

 

What Are Stocks?

To put it simply, a stock is a type of investment where you have very small ownership and shares in either a singular company or a bunch of companies mixed into one fund. Stocks are sold on the stock market to investors who want to invest in companies and/or funds that they feel will succeed over time.

There are many secondary markets (stock exchanges) and online brokerage accounts that you choose to go with when you invest in stocks, and the main reason behind being in these stocks is to make a long-term profit by being part of a company or fund that grows over time.

With stocks, with long-term growth in mind, you can also earn dividends within a company or fund that you own, which are given to you either regularly (typically two or four times a year) or via a one-off payment.

 

Different Types of Bonds

There are so many different types of bonds you can choose from when you begin investing, but there are a few main types of bonds that people regularly invest in.

  1. Government Bonds (Treasury Bonds in the US): The bonds issued by a government (you lend money to them) and they pay you back with regular interest payments.
  2. Corporate Bonds: These are the types of bonds that are issued by companies, rather than governments, meaning that you are lending a company money for their project (typically more risky to trust compared to other types of bonds as you’re trusting a company to pay you back, not the government).
  3. Municipal bonds: These are issued by your local government and authorities, rather than the main government. You lend money for local projects, industrial work, and many more. In return, you receive coupon payments and your initial investment back at the end of the bond’s maturity date.

 

Different Types of Stocks

Among the different types of stocks you can have shares in, here are the core types of stocks you’ll come across:

  • Preferred stock (a stock similar to the bond prioritising fixed dividend payments)
  • Common stock (a share and ownership in a company)
  • Small, mid, or large-cap stocks (stocks based on how big the company is)
  • Growth stock (stocks with high earning potential but big risk)
  • Value stock (lower growth rates short term, but focus on long-term fundamentals)
  • International stock (investing in a company from another country)
  • Index funds (a group of companies mixed together tracking a market index)
  • Mutual funds (the same as an index fund but managed/overseen by a fund manager)
  • ETFs (Exchange-traded funds that try to replicate the performance of an index)

 

The Main Differences of Bonds and Stocks

Although they are investments that people make to earn interest, there are some glaring differences between bonds vs stocks which we’ll break down for you below:

 

1. Owning vs Debt

With stocks, you own a shareholder in a company, but with bonds, you essentially go into debt by giving the government or company money for a project. Now, this may sound like stocks are the clear winner in this scenario, but you need to remember that you’re almost always guaranteed your money back with bonds, and they are less risky in most cases.

 

2. Risk Profile

As we mentioned briefly above, bonds are often less risky than stocks, as you’re typically always going to get your initial investment back at least. However, on average, the stock market outshines the performance of bonds in terms of returns but may be slightly more volatile in the grand scheme of things.

 

3. Fixed Income vs Capital Gains

Bonds often pay out in fixed interest payments, whereas the stock market will return in whatever direction the market is heading.

 

Pros and Cons of Bonds and Stocks

To give you a better idea and judgement of what they’re better or worse in, here are the pros and cons of both bonds and stocks.

 

Advantages of Bonds

  • They will provide you with a low-risk, almost guaranteed income
  • They have a higher yield than savings accounts most of the time
  • Great stable source of income for those nearing retirement (or who are retired)

 

Disadvantages of Bonds

  • Your bond investment may not keep up with the high rate of inflation
  • Your investment can suffer when interest rates rise
  • A corporate bond issuer could potentially go bankrupt (unlikely)

 

Advantages of Stocks

  • They average a much higher return rate
  • You will often beat inflation with your stock investments
  • They have a long-term history of generating wealth for successful investors
  • You have so many options to diversify your portfolio
  • There is no limit to how much you can earn

 

Disadvantages of Stocks

  • If you invest in an individual company and they fail, you’re in a bad spot
  • The rise and fall may be hard to deal with in your emotional side of finances
  • Higher risk than bonds

 

Should You Invest in Bonds or Stocks?

Whether you invest in bonds or stocks depends on a number of factors, including age, risk tolerance, and emotional strength when it comes to investing. If you’re a young investor, we would recommend you hold more of your money in the stock market with an index fund, as the power of compounding over time will make you extremely wealthy long-term.

However, if you’re nearing retirement, and looking for guaranteed returns, we would advise you to invest more heavily in bonds, as they will give you more predictable returns.

If you’re somewhere in the middle, the stock market would still be the best place for long-term growth, but once you start nearing retirement, you may want to add more bonds into your portfolio to balance the risk.

At the end of the day, both bonds and stocks hold risk, but they’re both incredible tools for wealth generation, so do your due diligence, research and understand both, and then make an informed decision based on your personal situation.

Are you searching for investments which outperform bank interest rates?​

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