Stocks vs Bonds Basics

For investors, the main difference between stocks and bonds is their risk/reward ratio. Stocks offer potentially higher returns/losses than bonds. Another difference between stocks and bonds is that the former represent a partial ownership of a company while the latter represent a debt the company has with the bondholder.

Stocks

Different Kinds of Stocks

Common Stocks
Common stocks give the investor partial ownership of a company, the right to claim dividends if the business offers them, and one vote per stock owned to select board members.

Preferred Stocks
Preferred stocks give the investor partial ownership of a company and a fixed dividend. No voting rights are given to the stockholder in this case. If the company is liquidated, owners of preferred stocks will be paid first than owners of common stocks.

How Stocks are Created

Before a company creates or issues stock, it needs to register a statement to the competent regulator (e.g. SEC). Then, an investment bank analyzes the company to determine both the company and the stock’s value. The investment bank also gives the company some publicity so potential investors become aware of the sale at the IPO (Initial Public Offering).

Benefits of Investing in Stocks

Stocks can give the investor very high returns. Liquidity is also one of their features. This means, you can easily find a buyer for the stocks you own when you decide to sell them if they are traded publicly. Additionally, taxation of stocks can be delayed. For example, if you earned some money with one stock but lost an amount with another in that same year, you can subtract the loss from the earnings before calculating the taxes you have to pay.

How to Buy Stocks

Stocks can be bought either directly from the company or through a stock broker. If you buy it directly, you may find it hard to find a buyer for them. The best option is usually through a stock broker. These are either online (such as E-trade) or physical brokers (such as Charles Schwab). An account should be opened and the respective amount be deposited.

Bonds

Different Kinds of Bonds

Government Bonds
Government bonds are considered the safest and have a maturation of over 10 years. Fixed-income securities offered by the government with shorter durations are known by other names, i.e. notes are those that mature between 1 and 10 years and bills are those that mature in less than a year.

Municipal Bonds
Municipal bonds are similar to government bonds but are a bit riskier since they are offered by local governments such as cities.

Corporate Bonds
Corporate bonds are those offered by companies. These usually offer higher yields than government and municipal bonds because they involve higher risk than them.

Zero-coupon Bonds
Zero-coupon bonds are those bonds that don’t give regular coupon payments and are offered below par value. For example, a zero-coupon bond with a par value equal to $1,000 and a maturity of 10 years could be bought at $700 depending on its interest rate.

How Bonds Work

Stocks vs bonds differ in how easy it is to understand each one of them. Understanding how stocks work is a straight-forward process. To understand how bonds work, first we have to look at each of its components.

Face Value: this is the amount received if the bond is kept until its maturity date.

Maturity date: The date in which you will receive the bond’s face value plus the interest due in that date.

Coupon rate: the interest rate you will receive each year given its face value. For example, a bond with a face value of $10.000 and a 6% coupon rate will give you a total of $600 annually.

Yield to Maturity: It is the predicted rate of return the investor will get if the bond is kept until its maturity date.

Current Price: The current price of a bond. It is equal to face value when the bond is first issued (not applicable in zero-coupon bonds).

If an investor buys let’s say a bond with a face value of $10,000, a coupon rate of 6%, a maturity of 10 years and he keeps it until maturity, he will receive $600 annually plus the $10,000 in 10 years.

When it is issued, the coupon rate and the yield to maturity are equal (6%). However, as time goes by and depending on market conditions, the yield to maturity (YTM) can vary. Let’s say in the above example that the YTM goes down a few years after the investor bought it. In this case, the bond’s price would go up and the investor could sell it for a premium. If the YTM goes up, the bond’s price would go down.

Benefits of Investing in Bonds

The main benefit of investing in bonds is that they are a safer investment than stocks. Also, some bonds offer steady returns in form of coupon payments. Additionally, bonds offer guaranteed returns (if the bondholder keeps it until its maturity date) which are higher returns than those of savings accounts.

How to Buy Bonds

There is little difference between stocks and bonds in this respect. An investor should seek a bond broker and open an account with them. Other options include investing in a mutual fund that invests in bonds or looking for a discount or full-service brokerage. Government bonds can be bought directly through the Treasurydirect.gov site.

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Diversification

Why Diversification in Investing is so Important

Diversification is one of the basic building blocks of investing because it diminishes the risk associated with it. For example, a difference between stocks and bonds is how risky each of them is. Thus, instead of investing in stocks only (which would be risky), an investor can opt to put part of his money in bonds which would make his portfolio more balanced in terms of risk.

How to Diversify Based on Retirement Age

In general, younger people can take more risk than older ones. A common rule is to subtract a person’s age from 100 and put this amount in stocks. Thus, a 20 year old could have a stocks vs bonds allocation of (investing in bonds is that they are a safer investment than stocks. Also, some stocks offer steady 80%/20%). A 50-year-old would have a stocks vs bonds allocation of (50%/50%).

It is important to note that the above is only a general rule and isn’t applicable in all cases. This is because each person may have different goals, current financial status, and aversion to risk.