If you’re looking to start an investment portfolio, then you’ve probably heard of bonds and stocks. Both are essential components of a diverse portfolio, but they function in very different ways. Here’s a quick overview of the difference between stocks and bonds:
Stocks
A stock represents a small ownership stake in a company that has gone public. Successful companies that are looking to take the next step in expansion will often choose to go public, allowing it to sell equity in the company for cash. A company goes public by breaking itself up into shares and offering a fraction of those shares to the general public–this is called the Initial Public Offering (IPO). When you buy stocks, then, you’re purchasing partial ownership of a company–the value of the stock, and therefore the return on your investment, depends entirely on the success of that business. In most cases, you won’t receive any returns until you finally decide to sell your stocks.
Bonds
When you purchase a bond, you’re essentially providing a loan to a corporate or governmental entity. And just like any loan you might take out, bonds come with their own sorts of interest rates and payment plans. Every bond has a coupon, which guarantees that each year you’ll receive a certain percentage of your initial investment until the bond’s maturity date. So if, for example, you take out a five-year, $5,000 bond with a 5% coupon, you’ll receive $125 twice a year until the five-year mark rolls around. At that point, the bond will have matured, and you’ll receive the full principal ($5,000) back. In total, you’ll have made $6,250 from your $5,000 investment, making for a healthy profit of $1,250 over the course of five years.
The Advantages of Each
You essentially know what you’re going to get when you purchase a bond–the main risk you run is that the bonding entity could collapse or default, but the likelihood of this in most cases is close to 0%. Bond values are also prone to fluctuation, but very rarely do investors receive anything less than the full principal upon maturity. If you’re looking for reliable short-term income, then you should invest more heavily in bonds than in stocks, which don’t offer the same type of dependability.
But what you lose in stability with stocks is usually made up for in potential: the stock market can be volatile and unpredictable in the short-term, but over the long-term, intelligently invested stocks are thought to bring in a greater return than bonds. So if you’re looking to invest your money over the long-term future–we’re talking ten years or more–with a higher ceiling on returns, it’s probably worth leaning on stocks more heavily than bonds.