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When it comes to investing, few topics are more confusing to the majority of investors and the general populace than the difference between stocks and bonds. Fortunately, the answer to this question is not as complicated as it might seem.
This article will briefly outline a stock and a bond and then explain the key differences between the two from an investor’s perspective.
What Is a Stock?
A stock, simply put, is a share of a company that:
represents partial ownership of the corporation, and
can be bought and sold
Technically, stock refers to the equity (the value of ownership interest in a corporation), and pieces of stock are called shares. It is not uncommon, though, for the word ‘stocks’ to be used in exchange for shares.
Stocks are originally issued as a way for a corporation to finance itself by raising money and avoiding taking on debt. This is called equity financing. A corporation could issue stock, for example, to raise money for more employees so that it can expand and generate more revenue.
After they are initially released, stocks are sold on secondary exchanges. The two main secondary exchanges in the U.S. are the New York Stock Exchange and NASDAQ. Corporations do not typically generate income from these transactions, since their shares are resold again and again.
The main reason why investors become involved with stocks these days is to turn a profit by purchasing the stock at a certain price and selling it at another price. This is done because the investor believes the value of a stock will rise because the corporation is profitable (or will be in the future) and has upside growth potential.
An investor can also short-sell a stock by essentially betting that the value of a company will drop in the near future. The difference between the original price and the lower price represents the investor’s profit.
A stock is a piece of a corporation that signifies partial ownership (equity) in the company
Stocks are issued as a way to finance a company without going into debt
Stocks are traded on secondary exchanges like NYSE and NASDAQ
What Is a Bond?
A bond is another tradable security that is built on debt instead of equity. A bond:
represents an obligation to repay borrowed money, and
makes the owner a lender instead of an owner
Bonds are essentially loans. When a corporation or a government entity (like a city) issues a bond, it raises money from investors, who then become lenders. In exchange for giving the corporation money, investors receive a promise that they will receive their initial investment at a certain time in the future, plus any interest that has accumulated on the bond.
For example, let’s say a corporation wants to raise $100,000. It can do this by issuing 10,000 bonds worth $10 each. When an investor buys one of these bonds, he or she will receive $10 when the bond reaches maturity, or, the date at which the bond can be redeemed. If this bond has a maturity of 5 years, the investor will receive $10 five years from now, plus interest accumulated over five years. If the interest rate is 2%, and the interest is compounded (calculated) each year, the owner will receive $11.00 – a return of 10%.
Bonds are a form of debt financing, which raises money for a corporation or public entity by creating liabilities. This is different from equity financing because debt must be repaid. The value of a bond, or its yield, is determined by how likely it is to be repaid and the coupon, which is the interest rate that the bond holder will be paid over the life of the bond.
There are many different types of bonds (i.e. a bond issued by a city is a municipal bond) but all share the same basic characteristics.
A bond is a loan to a corporation or public entity
Bonds must be repaid by the bond issuer and represent debt
The value of a bond is basically determined by the interest rate
How Are They Different?
A stock and a bond have several practical differences investors need to know.
Ownership versus Creditorship
The first involves the notion of ownership versus creditorship. When someone buys shares of a stock, he or she is a partial owner of a corporation and may or may not have voting rights. When someone buys a bond, he or she becomes a creditor of the corporation.
Fluctuations in Value
Another crucial difference is how stocks and bonds fluctuate in value. A stock’s value, or stock price, is determined by a mixture of fundamental factors, like earnings per share (revenues divided by the number of outstanding shares) and a valuation multiple, like the price-earnings (P/E) ratio. Supply and demand and other financial/economic factors also play major roles, so assessing stock price doesn’t follow a clear-cut formula.
Bonds, on the other hand, fluctuate in value primarily on the market interest rate, the length of the maturity, the investor’s discount rate (a rate that determines how much a certain amount in the future is worth to you now), and the par value, or face value of the bond. Investors can look to interest rates as a key indicator of how much a bond will be worth in the future.
Risk versus Reward
Stocks and bonds also differ based on risk versus reward.
Generally speaking, stocks carry more risk than bonds. This is because stocks can fluctuate dramatically for a wide variety of reasons, many of which may not be clear at all to the investor.
Bonds, on the other hand, are priced partially based on risk, so an investor can find bonds that suit their tolerance for risk. Buying a bond that has been rated as investment grade means you are more than likely to receive your investment back at maturity, plus interest, unless the corporation or public entity fails. Historically, bond markets are also less volatile than stock markets. Perhaps the “safest” investment in stocks or bonds is found with bonds issued by the U.S. Treasury. These bonds routinely have the lowest risk because the full faith and credit of the United States government is behind them.
Stocks may have greater risk, but they also offer greater rewards. A bond’s return, by comparison, rarely outstrips a stock. A municipal bond, for example, has returned an average of 4.2% since 1925, compared to an average return of 5.3% for Treasury bonds, 5.8% for corporate bonds, and 10.7% for stocks.
Where and How They Are Traded?
Finally, stocks and bonds are traded differently. Stocks are originally issued by corporations in initial public offerings (IPOs) in what are called primary exchanges. They are then sold and re-sold in secondary changes like the ones mentioned above.
Bonds, by contrast, are usually offered at public auctions for government bonds and over-the-counter (OTC) markets that are decentralized for corporate bonds. Investors wishing to buy and sell bonds typically do so through brokers, or those authorized and licensed to trade on an investor’s behalf.
A stock represents ownership; a bond represents creditorship
Stocks and bonds use different factors to determine their value
Stocks are inherently riskier, but carry more upside profit potential
Stocks are bought and sold on stock exchanges; bonds are bought through OTC markets
Stocks and bonds are very different, but both, in the end, are tradable securities that represent the potential to grow your investment over time.