Which is a better investment – stocks or bonds?
Before you start to invest, you need to know the difference between them – and which combination is right for you.
Investing is an activity that can help you expand your wealth. There are several assets that you can use to increase the value of your portfolio – a business, real estate, stocks or bonds. Most assets provide either income or capital appreciation. Income is a fixed return that you might receive monthly, quarterly, semi-annually or even annually.
For example, if you owned an apartment and rented it to a tenant, you would receive a monthly rental income. Capital appreciation has a variable return. For example, you don’t know exactly how much money you could make when you purchase an asset such as gold.
Stocks and bonds allow you to benefit from capital gains (the change in the price of the asset) as well as interest or dividend payments. The return will be based on the risk you are willing to accept. Low risk generally produces a lower return, while a higher risk is usually accompanied by a higher return. So, before you start to invest in either stocks or bonds, you need to know the difference between them, and which combination is right for you.
The difference between stocks and bonds
Essentially, a stock provides you with the right to participate in the profits of a company. There are several different types of shares, including common shares and preferred shares.
Common shares: Common stocks represent a claim on profits, dividends and company voting rights. Investors who use their voting power generally get one vote per share and use that to elect company board members who oversee the major decisions made by the company. Common shares are for investors who are looking for a combination of capital appreciation and income (from dividends), with a greater focus on capital appreciation.
Preferred shares: When it comes to receiving dividends, preferred shareholders are given preference over common shareholders. The dividend received by a preferred shareholder is generally higher than the dividend of a common shareholder. The dividend can be fixed or variable. The dividend that is paid is at the discretion of the company’s board of directors. Preferred shareholders have limited voting rights, and the features of the shares are closer to a bond than a stock. This appeals to investors who are looking for a stable income.
Bonds: A bond is an obligation to repay a loan. Bonds can be issued by governments, including federal, state and local municipalities. In addition, public companies will issue bonds to borrow capital. When you buy a bond, you are loaning money to a company or a government with an understanding that they have promised to pay you back in full, with regular interest payments.
Which is better for me – stocks or bonds?
It depends on your appetite for risk. Stocks are generally considered riskier than bonds. This is because the volatility (or variance) of stock prices is nearly triple the volatility of bond prices. A higher level of volatility means that the price might move a lot more in the future. While the price can go up and down, most investors are concerned about a decline in price when they purchase stocks or bonds.
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What should I buy – stocks or bonds?
If you are younger, have significant discretionary income and are looking for a robust return on your capital, stocks may be a better bet. This is because they potentially offer a higher return than bonds.
The long-term historical returns of the S&P 500 index (which is the US benchmark for stock indices), is approximately 8 percent per year. Since 1928, the historical return of the S&P 500 index is approximately 55 times greater than the return you would receive by owning the 10-year US Treasury bond (based on a $100 investment).
If you are older or are more risk-averse, a bond is likely to be a better investment. This is because bonds, in general, are less volatile and provide a stable income. This does not mean all bonds are safer than stocks. Bonds from creditworthy governments such as the United States are very safe, while emerging countries such as Turkey can be very volatile. You will also find volatile and less volatile corporate bonds.
Stocks and bonds are two important assets that can help you expand the size of your portfolio.
Nervous investors are often attracted to the safety of bonds, as they provide a steady stream of income. Historically, stocks have produced a greater return but are more volatile than bonds. The allocation of your capital to different assets should be based on your risk tolerance.
- If you are looking for a larger reward and are willing to take greater risks, stocks can provide those opportunities. A portfolio with a greater percentage of stocks over bonds could achieve this goal.
- One the other hand, if you are searching for a stable income, you are likely to find a broader range of opportunities by investing in bonds. A portfolio with more bonds than stocks could generate a stable portfolio.
FURTHER READING: How to invest in bonds – and whether you should right now