Everyone aspires to grow wealth to improve their life and their families’ quality of life. Purchasing real estate or starting a company is out of reach for many individuals. However, everyone with access to disposable income may invest some of their money in stocks and bonds.
Financial markets connect people looking to save money with other people or businesses looking to raise capital. The two most significant categories of financial markets are the stock and bond markets. Both of these essentially distinct strategies offer benefits and drawbacks. As we examine the distinction between stock and bond markets below, that will become clear.
What is the bond market?
Bonds are loans that you make to the government or a business. Simply put, when you acquire a bond, a business or government owes you money. It will pay you interest on the loan for a certain length of time before repaying the whole amount you paid for the bond.
Let’s say you spend ₦2,000,000 on a bond that yields 2% interest every year for ten years. This implies that you would get N₦40,000 in interest payments per year, which are usually dispersed equally over the year. In addition to receiving your ₦2,000,000 original investment returned, you would have earned ₦400,000 in interest after ten years. “Holding until maturity” refers to retaining a bond for its whole term.
With bonds, you typically know what you’re getting into, and over extended periods, the consistent interest payments may serve as a reliable fixed income source. Bonds typically have a period of a few days to 30 years, however, this varies according to the kind you purchase. Similarly, the yield, or interest rate, will change based on the bond’s tenure and type.
Bonds aren’t risk-free, however. You may not get your money back and interest payments will cease if the firm files for bankruptcy during the bond duration. Bondholders, however, get paid before other creditors and stockholders, even in the worst-case situation of a bankruptcy liquidation.
Depending on the kind of bond, you may purchase it directly from the government or a government agency, via mutual funds, online brokerage accounts, or exchange-traded funds (ETFs).
Types of bond
- Treasury bond: These kinds of bonds are issued by the federal government of a country. Since the government supports them, investing in them is comparatively secure, however, their yields are typically lower than other bonds.
- Municipal bonds: These are bonds issued by the state and municipal government.
- Corporate bonds: These are issued by public and private corporations. They have a higher credit risk than treasury bonds and municipal bonds.
Benefits
- A reliable, steady source of revenue.
- Relatively safe
- Value is protected against inflation by a higher return than savings
Drawbacks
- May lose value if the bond issuer is unable to pay interest or redeem the bond at maturity.
- May lose value if interest rates rise and the bond is sold before it matures.
- Long-term investments in equities have typically underperformed.
What is the stock market?
Stocks stand for equity, or a portion of ownership, in a business. A small portion of the business is what you get when you buy stock; one or more “shares.” The more shares you buy, the more of the business you own.
Suppose you invest N2,500,000 (50 shares at N50,000 each) in a company whose stock is valued at N50,000 per share. Imagine now that the business continuously does well over several years. Since you own a portion of the business, its success also affects you, and the value of your shares will increase in tandem with the company’s value. The value of your investment would grow by 50% to N3,750,000 if the stock price increased by 50% to N75,000. After that, you may make N1,250,000 by selling those shares to another investor.
Naturally, the reverse is also true. Your shares’ value may drop below what you paid for them if that business does badly. In this case, you would lose money if you sold them.
Additionally, stocks may be excellent sources of income, usually in the form of dividends, which are sums of money that a business pays to its owners directly. While not all equities pay dividends, more established, reliable businesses that make more money than they need to finance expansion and upgrades often give back the remaining amount in dividends.
Types of stock
- Common stock: This is the most common type of stock. In addition to having an ownership position in a business, you often can vote on shareholder issues at the annual shareholder meeting.
- Preferred stock: Preferred stockholders get dividend payments ahead of common stockholders, but they cannot vote. Additionally, preferred investors are given precedence if a firm files for bankruptcy and its assets are liquidated.
Benefits
- Can generate more returns than bonds
- Anyone with some spare cash may easily obtain it.
- Very long history of being a dependable source of long-term profit.
Drawbacks
- The danger of irreversible losses if the business fails.
- Losses are increased by volatility, particularly for investors with short time horizons.
- It may be emotionally taxing to endure stock declines due to market fluctuations.
Key Differences
Although the goal of both products is to increase your money, they vary greatly in how they do this and the rewards they provide. Let’s explore some of their differences:
Debt vs equity
The primary distinction between bonds and stocks is that bonds allow you to lend money to a business or the government, while stocks offer you a stake in a corporation.
Usually, when someone mentions the equity and debt markets, they are talking about stocks and bonds. In order to generate money to expand their operations, corporations often issue stock, which allows investors to profit from the company’s future development and success.
Purchasing bonds entails creating a debt that must be paid back with interest. Although you won’t own any stock in the business, you will agree that the government or business must pay the principal amount at the end of the term as well as set interest throughout time.
Fixed income vs Capital gains
Another distinction is how they generate income: bonds give you set interest over time, but stocks must increase in value so you may sell them for more than you paid for them.
You must sell the company’s shares for more than you paid to turn a profit or capital gain if you want to benefit from stocks.
Bonds provide income via consistent interest payments. Although bonds may be sold for a capital gain, the fixed-income component of these securities is what many conservative investors find most alluring. In a similar vein, certain stocks provide fixed income that is more akin to debt than equity; nevertheless, this is often not the reason why stocks are valuable.
Price relationship
The fact that stocks and bonds often have an inverse price relationship—when stock prices increase, bond prices decrease, and vice versa—is another significant distinction between them.
Bond prices usually decline due to decreased demand as stock prices increase and more individuals purchase to take advantage of the gain. The demand for and price of bonds, on the other hand, tends to rise when stock prices decline because investors prefer to switch to these traditionally lower-risk, lower-return products.
Taxes
Bonds and stocks are taxed differently because they produce different amounts of cash. While earnings from the sale of stocks are subject to capital gains tax, bond payments are often subject to income tax.
Risks and returns
Stocks are often riskier than bonds because of the many reasons a company’s operations may deteriorate. The greatest danger associated with investing in stocks is that their value may decline after you buy them. A company’s stock price may drop if its performance falls short of investor expectations. Higher rewards, meanwhile, may accompany that increased risk.
Bonds tend to be more stable than stocks, but, this reduced risk usually results in lower returns.
Which one is right for you
Bonds and stocks are not superior to one another. They have distinct functions, and a combination of both might be advantageous for many investors. A portfolio with a mix of stocks and bonds is more diversified and perhaps safer than one with just stocks.
Bonds give stability and steady income in the form of interest payments, whereas stocks offer larger returns over time due to corporate development. By combining the stability of bonds with the volatility of the stock market, investors may reduce market downturns and achieve their financial objectives. Diversification is a key strategy for controlling investing risks.
Several theories might assist you in deciding how to divide up stocks and bonds in your portfolio. According to one theory, the proportion of equities in your portfolio ought to be equal to 100 minus your age. Therefore, if you are thirty, your portfolio would consist of 30% bonds and 70% equities. It may be 60% bonds and 40% equities if you’re 60.
The basic notion here makes sense. By putting more money into bonds and less into equities as you get closer to retirement age, you can shield your nest egg from volatile market fluctuations.
The majority of investors base their stock/bond allocation on their level of risk tolerance. How much short-term volatility are you willing to accept in return for more robust long-term gains?
Think about this: Compared to a portfolio of 100% bonds, a portfolio of 100% equities has almost double the chance of ending the year at a loss. Are you prepared to endure such risks in exchange for a better long-term return?
It’s up to you to choose the investment option that best suits your needs and financial objectives.
Conclusion
Bonds and stocks are powerful financial instruments that can help you grow your wealth over time. They have several differences, but one thing they have in common is that they can both provide you with financial gains. There shouldn’t be a choice between them; you should invest in both for a well-balanced and diversified portfolio.
