The terms “stocks” and “bonds” are often mentioned in stock exchange and financial media publications as types of capital investments. For those with limited knowledge of investment opportunities, or new to trading on the financial markets, this article presents an outline of what these terms mean, and compares them as an investment.
Stocks, more commonly known as “shares,” represent equity financing. When you purchase a share, you are in effect buying am ownership share of whichever commercial organization you have chosen. This can be illustrated with a simple example. If a publicly listed company has a share capital divided into 100,000 $1 shares, and you decide to purchase 10,000 of those shares you will own ten percent of the business.
Of course, in reality most listed corporations have share capital of many millions, which means that the average private investor is likely to own a much lesser percentage of the business. However, irrespective of the size you will still own a share of the business and, therefore, have some, albeit limited, control over the future business activities.
When you purchase a bond, you are embarking upon what is known a debt financing. In simple terms, this means that you are lending the company money. Bonds are not restricted to commercial organizations. Governments and states can also offer them.
Bonds work in a similar way to a loan you might arrange with your bank, except that in this case the capital is repayable at the end of the agreed term. By purchasing a bond you are agreeing to lend the commercial or government organization a set amount of money for an agreed time at a pre-determined rate of interest.
To compare stocks and bonds from an investment viewpoint, a number of factors have to be taken into account.
The price of stocks fluctuates from minute to minute, as you will see from watching exchanges at work. A bond price tends not to be so erratic. Stock prices are determined by the financial markets and based upon the value those markets place in the company, which is usually affected by how well it is performing. Prices can go up or down.
Bond prices start on the basis of a set figure. They also fluctuate, but in the case of bonds this fluctuation is driven by how their earnings (interest receivable) compare with other interest rates.
With stocks you can buy as many or few shares as you want or can afford. With bonds, when first issued there is usually a set price for a block. For example, in many cases the initial offering of a bond may be in $5,000 units. Even after the initial offering, a bond will still have a set cost, for example, it may be set at $100 unit.
3. Time held (maturity)
Stocks can be held for as long as you wish. As you are buying a share of the business, the management cannot dictate when, or even if you may sell it. You can therefore keep the share for a matter of moments or for several decades. The choice is yours.
When a bond is originally offered, it will state how long the term of ownership will last. For instance, it may be a five-year or thirty year bond, but it will have a definitive term. At the end of that term, the maturity date, the bond face value has to be repaid to the bondholder.
The earnings differ between these two forms of investments. Shares receive dividends. However, these are determined by a number of factors. Firstly it is up to the management whether a dividend will be declared or not. Secondly, the performance of the business may determine the size of the dividend.
With a bond there is a fixed annual rate of interest, for example 5%, which is payable throughout the term during which the bond is held.
5. Future potential
Both shares and bonds can go up or down in price, so there is a potential gain or loss available in both cases. However, with shares this is subject to the performance of the business and the financial market forces. Other events, such as a proposed takeover can also affect the share price, potentially increasing it in the case of the target company.
The fluctuation of bond price is directly related to the value of the interest being received from them when compared with market rates. For example if the market rate is 3% and the bond pays 5% it will be worth more, however the reverse is also the case, where if the bond rate is less than market rates it will have a lower value.
6. Investment benefit/disadvantage
Both stocks and bonds have a place in an investment portfolio because of their differing risk factors. Stocks fluctuate more than bonds. However, although there is opportunity for greater growth, the risk is higher too. Bonds are repayable at the determined time and seen to incur less risk. Whilst there is still a potential for loss, bonds with a better stock market rating are considered to be reasonably secure.
Wise investors spread their risks by incorporating both stocks and bonds in their portfolios.