Stocks and bonds are both important investment vehicles which (except for government bonds) involve investing in private corporations in the hope of receiving a favourable return on the investment. However, they are two basically different types of investments, which is why a balanced portfolio includes both. The essential difference between stocks and bonds is that a stock is a share in the ownership of the company, which will hopefully rise in value (leading to profit for the shareholder when she or he sells the stock), whereas a bond is a loan advanced to a company, which will hopefully be paid back on schedule.
– About Stocks –
Stocks, also known as shares or equities, are units of ownership in a company, which (for publicly traded companies) can be bought and sold on a stock exchange. When a person invests in stocks, he or she is literally buying a piece of the ownership of a company. This is a miniuscule piece, although it does give the shareholder the right to attend annual meetings of shareholders and to vote at those meetings in accordance with the number of shares they hold. One can, for instance, buy stock in IBM (IBM), Microsoft (MSFT), or Apple (AAPL).
On the stock market, the value of stocks fluctuates regularly in accordance with buyers’ and sellers’ perceptions about how much value should be attached to equity in a company. Many factors go in to such valuations, not least subjective perception, but in general a company’s stock will rise when investors expect that it will have higher profits in the future, and will decline when investors fear that it will lose money in the future. Assuming the company survives long enough, you can hold stocks indefinitely. Eventually, however, an investor then sells his or her stocks. Profit can be made in investing if the stocks are sold for higher than they were purchased.
The greatest risk in owning stocks, however, is that the company will decline, and perhaps even go bankrupt. Since a stock is a share of ownership, when a company collapses one’s entire investment can be lost. Companies are typically wound up after their debts far exceed their assets, and shareholders, as owners, come very far down on the list of people eligible to receive a share of the distribution of the remaining assets.
– About Bonds –
In short, the differences between stocks and bonds is that stocks are units of ownership in a company which may rise in value over time if the company performs successfully, while bonds are loans advanced to that company which are paid back on an agreed-upon schedule. Although the financial media typically speaks of buying and selling bonds in the same manner as buying or selling stocks or other investment vehicles, in essence a bond is entirely different: rather than buying ownership in a company, a bondholder has actually loaned money to the company. The “bond” itself is the contract which specifies the value of the loan, the interest which will be paid on it, and the date at which the loaned money will be paid back.
In addition, although corporate bonds are numerous, what separates the stocks from the bonds market is that public (government) institutions issue bonds as well as private-sector corporations. Government savings bonds, in the past, have been a popular savings investment for individuals in several Western countries. As with stocks, there is always a risk that bondholders will lose their entire investment if the company collapses. However, bondholders are creditors rather than owners and therefore may be in a position to receive some of the money they are owed first.
Despite being loan contracts rather than ownership shares, bonds are still regularly bought and sold on the market – and many governments use these trades, to an extent, to manage the value of their currency. This is because, at any given time, the relative value of a bond may be quite different than the specified interest rate. The value of a bond from a company on the verge of bankruptcy will be very low, since it probably will not meet its payments; this is why when such companies receive new loans, they do so at very high interest rates (and bonds from companies on the brink of bankruptcy are known as “junk” bonds for this purpose).
In addition, and speaking on the macro level of the markets rather than the micro level of individual bonds, the value of stocks and bonds fluctuates but is related. In an economy which is growing and where credit is plentiful, stocks may be relatively valuable because companies are expanding, but bonds may be relatively poorly performing investments because interest rates are low. In contrast, when the economy contracts, stock markets fall because companies are in difficulty, but bonds may become more valuable because higher interest rates can be charged on loans.