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Stocks and bonds are two types of securities that are quite different but often referenced together in investment planning discussions. Stocks and bonds have their own advantages and disadvantages, and both can be fruitful if used correctly. Though they work in very distant ways the success of any portfolio depends on these two investment types.
So, what’s the difference between the two?
The major difference between stocks and bonds is that with
stocks you are a partial owner or own a small portion of a company, whereas. With bonds, you’re loaning a corporation or government.
Another difference is how. They generate money or profits: equity must grow in resale value, while bonds usually pay fixed interest over time.
What are stocks?
Stocks as mentioned represent partial ownership in a company. When you invest in a share of stock, you have the right of
ownership in a company. As a company performs well over time, share prices can increase and the investor makes profits.
Of course, the opposite is also true. If that company performs
poorly, the value of your shares could fall below the price you bought them for and you’d lose money if you sold them.
The most common reason for companies to issue shares to the
public is to raise cash for future growth that expands the profits horizon.
What are the different kinds of stocks?
There are many different varieties of stocks, including:
• Growth stocks: New or growing companies with earnings that have the potential to increase at a faster rate than the market average.
• Corporate stock: Shares of growing and well-rounded industries
• Income (or high dividend) stocks: These stocks often pay steady dividends but the share price growth might be historically lower. Financial services, technology, energy, and utility companies usually pay high dividends.
• Blue chip stocks: Stocks of well-known companies that have strong growth and pay dividends as well.
What are bonds?
Buying bonds is equivalent to loaning money to a company or government agency. Once you loan the money, you buy a bond from the company or government, and you will pay interest on the loaned
money for a specific period. Keep in mind, that you don’t obtain an ownership stake in the company like in stocks when you invest in bonds.
Also, bonds with longer maturities pay higher interest rates because investors are taking on a bigger risk. Inversely, Quality bonds usually offer lower interest rates because of the lower risk involved. Liquidity varies in different types of bonds.
It is important to note that bonds aren’t completely risk-free.
During the bond period, if the bond issuer company goes bankrupt, the payment of the interest is stopped and the full principal may not be returned to the investor. The positive side of investing in bonds is you will know exactly what you are up against, and the regular payment of interest could be a fixed income which can be parked for further growth.
The duration of bonds:
The duration depending on the type of bond you buy varies from
anywhere between a few days to 30 years. Likewise, the interest rate also known as yield varies accordingly depending on the type and timeline of the bond.
Comparing stocks and bonds
Equity vs. debt
Typically, equity refers to stocks and debt to bonds. The well-known liquid financial asset is equity. Liquid financial asset means an
investment can be comfortably converted into cash and companies generally issue shares or equity to raise funds to expand business. This creates an opportunity for the investors to benefit from the future success of the expanded business of the company.
When you buy a bond amounts to issuing a debt that must be
repaid with interest without any ownership in the company. but the investor enters into a deal or sort of an agreement that the corporation or government must pay fixed interest over a set period of time, and also the principal amount must be returned at the end of that tenure.
Capital gains vs. Fixed income
The way stocks and bonds generate cash is entirely different.
If you want to make a profit from the purchase of the stock, the
shares of the company must be sold at a higher price than the bought price keeping tax deductions in mind. It is very important to note that the capital gains can be re-invested for further growth but the long or short-term capital taxes will be applied accordingly.
Similarly, if your aim is capital gains bonds can also be sold just like stocks on the market. However, the predictable fixed income remains the most sorted option among the many conservative investors.
Inverse performance
The most important point that all investors must know is the
inverse relationship between stocks and bonds concerning price. Simply put- when bond prices rise, stock prices fall, and vice versa.
Historically, people buy rising stocks to capitalize on the growth factor. On the other hand, bond prices would have fallen on lower
demand. Similarly, when the prices of stocks are in some downturn investors traditionally buy bonds that offer lower risk and lower return. During such a situation due to the demand for bonds, their prices increase too.
Taxes
The generation of cash or profits is different in stocks and bonds and hence the way they are taxed is also different. Payments by bonds are subjected to income tax. The returns from selling stocks are taxed under capital gains tax.
So in conclusion what’s the right allocation to buy stocks or bonds?
Some of the advisors believe that the percentage of stocks in
the portfolio should be equal to 100 minus your age. So, if you’re 40, your portfolio should contain 60% stocks, 40%. If you’re 30, it should be 70% stocks and 30% bonds.
Let`s assume you have a portfolio with 100% stocks and 100%bonds. A portfolio with 100% stocks is more likely to end the financial year in a negative than a portfolio with 100% bonds.
So you must know the right allocation to beat the market fluctuations be it short, medium, or long term.
You can never pin down which one is better, stocks vs. bonds
since they serve different purposes to many investors with varieties of portfolios.
The best solution is to have the mix of both, stocks and bonds
in the right proportion with a diversification tool that takes your risk and returns into consideration. This makes the portfolio safer under most adverse conditions and returns will be multi-folds under favourable conditions.
Finally, the best investment portfolio or strategy is the one that meets your individual needs.
