As the most popular asset classes, bonds and equities are often paired together when it comes to investment plans. However, both have different behaviors, risks, liquidity features, and returns.
While equities are considered high-risk investments, bonds may be ideal for those who prefer low-risk alternatives. Therefore, if you want to build your future wealth and plan to put your money into one of these two instruments, you must understand their differences and know the key aspects of each one.
Fortunately, that’s what you can do here. Read on to find the answers to your questions about both options and find out which one is suitable for your investment portfolio.
What Are Equities?
While the term “equity” is broad, it often refers to an ownership stake or share in a business. When you buy equities, you get a small part of a company, making you a partial owner. Stocks, for example, fall into this category.
The more shares you purchase, the greater the percentage of the business that you own. Therefore, if the company performs well, your shares’ value may increase. In other words, its success represents the success of your investment. However, in an opposite scenario, your shares’ value could drop below the stock price you originally paid, meaning you could lose money.
Buying stocks or equity shares is straightforward. Several online brokers offer different accounts or even low-cost and non-cost trades. Some also allow you to make a fractional investment, which means you can invest a certain amount of money in a stock that does not necessarily have to be a full share.
Those who want to make money from equities often buy shares in stable companies and hold them for years, hoping the business’s success will increase its value and allow them to make money in the future. In some cases, equity holders can also generate income through dividends.
However, each company decides whether or not to pay dividends to shareholders. Overall, high-quality and stable firms often return the remaining money to these investors if they generate more income than they need for growth or improvements.
Types of Equities
If you want to invest in equities, you have a few options to choose from, including:
Common stocks: Also known as common shares, these are the most popular type of equities and give holders a stake in a company and often a vote in shareholders’ meetings.
Preferred stocks: Also known as preferred shares, companies offer this type of equities with defined dividends, redemption dates, and redemption prices to shareholders.
Contributed surplus: The term defines the money paid to investors for shares sold above the par value.
Retained earnings: They define any amount not paid to shareholders as dividends that is retained for future needs or reinvestment.
Treasury stock: Also known as contra-equity account, it refers to the amount of common stock that a company buys back from investors and is deducted from the business’s total equity.
Advantages and Disadvantages of Equities
Besides understanding equities’ types and definitions, it is also essential to know their pros and cons before taking another step in your investment project.
These are the advantages of investing in equities:
Available to anyone with income who plans to invest
Potential increase in the value of the amount invested through capital gains or dividends
Easy accessibility through a minimal initial investment
Dividends paid by companies are often tax-free
Reliable investment option for those who want to generate long-term wealth
Increased liquidity, as most shares are publicly traded on major stock exchanges
These are the disadvantages of investing in equities:
Risk of volatility losses, especially for short-term investors
Market fluctuations that can impact investments, especially during stock market downturns
Risk of losses by the company’s poor performance or other difficulties
What Are Bonds?
Unlike shares, which are defined as partial ownership of a company, bonds are one of the fixed-income instruments representing a loan to a firm or to the government. In this type of investment, you do not buy a stake or share but lend money to an entity with a fixed interest payment, a nominal value the borrower must pay, and a maturity date.
Although bonds are less volatile than equities, they can also carry some risks. If the company you lend money to goes bankrupt, you could stop receiving interest payments. Sometimes, borrowers may not make the principal payment. However, even in worst-case scenarios, bond investors are prioritized to receive redemptions.
The financial benefit associated with bonds depends on their performance. As a general rule, bond prices fluctuate under the influence of the interest rate.
When interest rates rise, bond prices can lose value, while their value increases when interest rates fall. However, those who buy bonds at face value and hold them until the maturity date expires can enjoy high returns and get back the principal amount they invested.
If you want to make a bond investment, you only have to do an internet search. Many online brokers buy and sell all types of bonds, including those newly issued by companies or from a secondary market. There’s also the official Treasure Direct website, which offers treasury securities.
However, most investors choose exchange-traded funds (ETFs) or mutual bond funds to acquire and hold their assets. Such funds pool investors’ money through a collected fee or “expense ratio” to cover buying and selling amounts while making a profit.
Types of Bonds
These are the types of assets often available in the bond market:
Treasury Bonds, Notes, and Bills
As they are issued by the US government, these bonds are the safest options. Also, treasury bonds, notes, and bills are available with maturity periods ranging from four weeks to 30 years.
Since they are issued by state and local governments, municipal bonds are also safe. However, they tend to pay higher yields.
They are issued by private companies. Therefore, corporate bonds’ safety depends on the issuer’s solvency and financial strength. However, investing in this type of bond can result in higher future profits since they often receive a higher yield premium.
Advantages and Disadvantages of Bonds
Now that you know the key details about bonds and the bond market, you should take a look at their advantages and disadvantages to find out if they are the best option for your investment:
These are the pros of bonds:
Stable source of income
Higher yield than other fixed-income instruments or savings
Higher inflation protection than other fixed-income alternatives
Potential capital gain by selling the bonds higher than the purchase price
Can be used as collateral when applying for a loan at a bank, especially if you hold government bonds
These are the cons of bonds:
Loss of value if the holder sells the bonds before maturity and interest rates rise
Risk of price fluctuations as interest rates rise or fall, especially for long-term bonds
Lower long-term returns compared to stocks
Comparing the Two Asset Classes
Both bonds and equities can help you diversify your portfolio and increase your wealth. However, the way in which both investment instruments behave and can give you profits are different. Know the main dissimilarities between them below:
Equity Vs. Debt
There’s a reason why equities are the most popular financial instruments: both companies and investors can benefit from them. When equities are issued, corporations can quickly raise cash to expand their operations. Meanwhile, investors get a chance to see their riches grow. However, it only happens if the business succeeds.
Since bonds involve interest payments, if you buy these assets, you enter into an agreement with a company or the government. Therefore, you will receive fixed interest earnings over time besides the principal payment.
Capital Gains, Fixed Income, and Interest Payments
Another important difference between bonds and equities is how they can help you make money. If you buy equities or stocks, you often have to sell the company’s shares at a higher price than you bought them. Depending on your investment strategy, you can view capital gains as income or reinvest them. However, unlike dividends, both long-term and short-term capital gains are taxed.
If you buy bonds, you can earn money through regular interest payments according to the agreement you reach with the company or the government. However, their distribution may vary.
Treasury bonds and notes require interest payments every six months until maturity, while Treasury bills’ interests are paid only upon maturity. In contrast, if you buy corporate bonds, you can agree with the borrower whether interest payments should be made every six months, quarterly, monthly, or at maturity.
As another important difference, equities and bonds have an inverse relationship when it comes to pricing. In simple terms, when stock prices rise, bond prices fall, and vice versa.
Consequently, when stock prices increase, investors usually buy stocks hoping to benefit from that growth, causing demand for bonds to decline. However, if stock prices fall, investors opt for less risky options such as bonds, even if their yield is lower, causing their demand and value to rise.
As mentioned, bond yields also depend on interest rates. When the Federal Reserve announces an interest rate hike, newly issued bonds have a higher yield than existing ones, causing demand to rise and boosting prices. However, lower interest rates reduce the yield on newly issued bonds, decreasing their demand and value accordingly.
During economic downturns, for example, the Federal Reserve often lowers interest rates. In these cases, stocks tend to plummet but the existing bonds’ value often rises.
Potential Risks and Rewards
Both bonds and equities can also be at risk due to various factors. Stock investments could lose value after purchases if a company’s performance is poor or below investors’ expectations, for example. In this sense, stocks’ prices are more likely to fall than bonds’ value.
However, the higher risk may come with higher profits in the future. The stock market’s average annual return is around 10%, meaning equities can help investors make a good amount of money in the future. If issued by the government, bonds are usually safer and more stable. However, low risk can also translate to low return. The US bond market has an average yield of 4.76% over 10 years.
In contrast, corporate bonds typically have varying levels of risk and return. Some companies are more likely to go bankrupt, increasing the risk linked to the bonds they offer. Furthermore, these bonds are divided into two categories: investment grade and high-yield bonds.
Also called junk bonds, high-yield options have a lower credit rating and higher returns, but the risk is usually higher. Therefore, defining the best choice for your investment portfolio depends on your risk tolerance and the results you expect to obtain.
Final Thoughts: Is It Better to Invest in Equities or Bonds?
Like real estate assets or precious metals, bonds and equities are financial tools that can help you generate income in the future or create wealth in the present. However, you must choose an alternative that suits your plans and investment capacity. Equity holders may experience uncertainties due to tense periods of volatility. However, stocks can be better than bonds when it comes to building wealth in five years or more.
Do you prefer safe investments? If so, bonds may be the ideal financial instrument for you. However, you should be aware that they may underperform in terms of earnings, especially if you expect to make money in the long run. Also, although they are more stable, bond prices can fluctuate depending on interest rate movements. In other words, you could also face uncertainties if you choose this option.
Therefore, as a general rule, you should set a financial objective and pick an investment instrument that allows you to achieve it. Some experts recommend investing in stocks the further you are from reaching that goal. Then, as you get closer to it, you can move your assets into bonds. However, remember that choosing one or another depends on your future plans and the options available to maximize and protect your wealth.