Stock market investment has been around since the 18th century and has made countless investors well-off in life, which is why people will always try to get into this business.
Buying stocks instead of bonds have advantages and disadvantages (deep level of market research is always needed), but to understand why the latter is now behind in terms of performance, we need to understand the difference between the two. This will also help you make the right choice for your portfolio.
Let’s begin by checking the key features of both stocks and bonds.
As you may have already known, stocks and bonds differ in many categories, including structures, payouts, returns, and risks.
Stocks allow more return potential than bonds but it also comes with more volatility as well. You probably heard this statement so many times before that you just accept it as it is. Have you asked yourself why? Why have stocks historically have higher returns than bonds? What makes bonds usually less volatile?
Knowing these trends will help you become a better investor.
A Basic Example
Let’s say that you are starting up a new business with you as the sole owner as well as the only employee. It would take $2,000 to start operations but you only have $1,000, so you’ll need to get the other $1,000 from someone with the promise to pay $100 per year for the next 10 years, at the end you will repay your original $1,000 loan amount.
The first year, every expense has been settled, including your own salary, you noticed that your business earned $500. You pay your friend the $100 but kept the remaining $400. The lender has earned 10% (100 ÷ 1000) on the loan, while you earned 40% (400 ÷ 1,000) on your investment.
The next year does not go well for your business and after all, expenses have been paid your business has only earned $100. When you pay $100 to your lender, who has again experienced a 10% return you’ll be left with a 0% return, although your two-year return is around 20% per year.
Annually, you have the chance to earn more or less than the lender. If your business becomes successful, the returns will be exponentially higher than the lender; while if things don’t go as planned, you can lose everything.
Your loan is a contractual arrangement, so if need to call it quits, whatever money that’s left should go to your lender before you get any. With this, your position comes with greater risk, but you also gain better returns. If you don’t have an opportunity for greater return, there would be no reason to consider the greater risk.
Analyzing the Pros and Cons Stocks Instead of Bonds
Stocks, in essence, are a form of ownership representing an individual’s participation in a company’s growth. Usually, investors do not get any promises about any return from their initial investment. The profitability of the investment is based on the rising stock price, which, at the most essential level, relates right to the growth continuous performance of the company.
A bond is essentially a form of debt where you happen to are the lender instead of the borrower. It is a contractual loan made between investors (you) and institutions that, in return for your financing will pay a premium for borrowing, which is also known as a coupon.
Furthermore, the investor gets the bond’s face value after maturity. The guarantee of both payback and coupon payments are based solely on the ability of the borrower to create the necessary cash flow to repay bondholders.
If we’re talking about which security is better? It is actually neither since both stocks and bonds have their pros and cons, based on what you are looking for.
Pros of Buying Stocks Instead of Bonds
Stocks have the potential to create higher returns compared to bonds. Investors who want to tackle more risks than bondholders—and who would pick to have the benefit of having partial ownership in a company plus the unlimited potential of a rising stock price—would find better fulfillment investing in stocks.
By diversifying your investments and putting money into both stocks and bonds, you can make sure that there will be some security while leaving some chance for above-average returns through stock investments.
Cons of Buying Stocks Instead of Bonds
Stocks are generally riskier than bonds. The disadvantage therefore of stocks vs. bonds is that stocks won’t guarantee returns to the investor, while bonds typically offer fairly reliable returns via coupon payments. Therefore, the opportunity for high returns is better with stocks, but so is the chance of losing money.
Investors who dislike putting their money on gambles and only looking for safety of capital—who want a known periodic payment structure for a limited time frame should also consider simply investing in bonds.
The stock market investment provides the potential for higher returns provided you’re using the right broker and have educated yourself properly. Bonds, on the other hand, offer somewhat reliable returns and are more appropriate for risk-averse investors. Investors can definitely diversify by using a combination of stocks and bonds which help alleviate risk.
In the end, bonds will always be less volatile than stocks since certainties are there about income flow. And while unknowns surround the performance of stocks, which increases risk factor, bigger returns are definitely there. The potential to generate greater returns than bonds is a great pull for investors. Keep in mind that proper research and planning is important for any of these two options to work. Best of luck!