Looking for the safest ways to invest your money has no doubt led you to bonds at some point. That’s because bonds are seen as the safest way to make money with money. These are different than stocks and present far less risk.
Bonds pay a fixed income that will pay at regular intervals where stocks may not. A stock is a type of ownership in a company, and you’re not guaranteed to make anything off them.
Bonds will always pay, but at a lower rate than stocks. Lower risk means less reward so, learn more about them first.
What Are Bonds?
Very simply put, bonds promise to pay a certain amount of money over time. They also promise to return the original cost of the bond on a specific date.
That means that you can always be sure that you’ll get your money back once the bond matures. You’re essentially lending money to a government or company that will pay you back with interest.
You’ll get the interest over time with the original loan paid off on that specified date. That’s what makes them so low risk because you’re guaranteed all of the money from the beginning.
To make them even more reliable, if a company ever defaults on its interest payments, bondholders can garnish their assets. This is something that can’t be done with stocks.
Companies are never under any obligation to pay out on any stocks that you may hold. It’s just one more reason that bonds are much safer than any of the alternatives out there.
Companies must meet their interest payments on time or risk having the investors secure their assets to recover their investment in the bonds and that’s really the bottom line for the bondholder.
On top of all that, bondholders can also tell the companies, that they’re lending to, and how to use the money. That’s the best way to make sure that the companies aren’t wasting your money after you give it to them.
This type of control is called a “covenant” and can be used to ensure that the company will always have enough money and pay the interest on its bonds.
While it’s not necessary for every bond you buy, it should always be considered while you’re shopping around for the right portfolio. A little bit of control can go a long way toward putting you at ease.
Bond prices are also determined by demand. Companies with large debts will often offer bonds as a way to alleviate it. They take the money you spend on the bonds and use them to pay bills.
These are called security bonds and they’re some of the most common ones that you’ll find. The prices are usually determined by the amount of demand that companies have for their bonds.
If you find a company with many bondholders, then the chances are that its cost will be higher than that of a company with only a few.
How Stocks Differ From Bonds
As previously explained, when you buy stocks, you are paying for ownership of that company. Unfortunately, just like when you start a business, there is no guarantee of getting a return on your investment. The company you invest in may decide not to give any dividends.
Another scary thing about stocks is that your investment value can change day by day, dependent on the company’s business profits. If you are a company, stocks are safer than some other ways to fund your business. Although payouts are not mandatory, the company is protected from having its assets taken or possibly bankrupting as easily.
Although the corporation is not required to give investors dividends if the company is run well, investors should see a capital gain over time. Stocks can gain a virtually endless amount of profit if things go well, but just as quickly can lose everything in a short while.
Bonds, however, have a relatively low potential for growth and are fairly fixed as to how much change you can expect. With bonds, you can lose everything but may get at least some of your losses back.
You become an owner in the business when you buy a stock, but with bonds, you do not. That’s a major difference and why bonds are so much safer than stocks.
Major Difference Between Stocks And Bonds
- Bonds are very structured compared to stocks. Therefore, you will generally know what you stand to gain from owning bonds potentially.
- Some stocks pay out dividends or cash payments to their investors on a regular schedule like bonds but with much higher returns. The reliable quarterly or yearly income helps many retirees to maintain their previous lifestyle after 65 when chosen carefully.
- Unless a bond is a bond with floating, the investor has a contract with the exact amount they should receive. Stocks are riskier, and investors expect a higher return on their investments.
- Bonds offer greater safety than stocks, but the return on your investment is likely much less than with stocks.
- With bonds, the greater the level of safety, the less your return on investment is likely to be.
The one thing to really keep in mind is the fact that neither stocks nor bonds are likely to satisfy all of your financial needs. Most people opt for a collection of both because it offers a customizable model of risk and reward.
Disadvantages Of Bonds
The biggest disadvantage of bonds is simply the amount of time they take to mature versus inflation. Bonds do not increase according to the economy.
If you buy a bond now, it will mature and give you the same amount of money in the future that it would give you today. Typically, you will get a profit of no more than 4% from a bond.
Some years the cost of living can go up to 3% or more. When this happens, the gain from bonds will barely break even and cover that at 4%. This rate does not help your purchasing power. If it rises above 3%, you may even lose purchasing power.
Disadvantages Of Stocks
The major disadvantage of stocks is that you only profit when the stock prices go up. If they stay the same, your money stays the same as well. If they go down, your money goes down.
That’s the main risk that you’re assuming when you decide to buy stocks. They often fluctuate as much as 50% in any given year, making it hard for newer inexperienced investors to know when to buy and sell their stocks.
Owning Versus Lending
In order to really understand the difference between stocks and bonds, it helps to think of yourself as either an owner or a creditor. When you buy stocks, you’re buying part of a company.
That makes you an owner of it. That means that you do well when the company does well. When you buy bonds, you’re really acting as a creditor.
You’re lending money to the company and getting paid back with interest. It doesn’t matter how well the company does. They still owe you the amount of money that you gave them, plus a little interest.
Why You Should Own And Lend
Investing in both stocks and bonds is one way to have a diversified portfolio. Diversification helps investors increase their gains.
Diversification is not for everyone, but it helps them enjoy the benefits from both whiles alleviating the less desirable aspects. Having both stocks and bonds can help balance out an investor’s individual needs over time, making it an excellent option for many.
If an investor has some bonds in his portfolio and then decides to purchase stock, a common pulling back before each helps keep your portfolio more balanced than having just one or the other. It’s always going to be best to hedge your bets and go with both stocks and bonds.
When Companies Go Bankrupt
If you buy bonds from a company that then goes bankrupt, you still stand to lose everything. That doesn’t mean you don’t have any recourse, though.
Bondholders have the ability to seize a company’s assets to make sure they get their money back. This is something that you can never do with your stocks.
Bonds are really just loans that the company must pay back. Whether that comes from payments or from liquidation, you’ll still stand to get your money back.
A liquidation preference, in the event of bankruptcy, is a built-in clause in a contract that identifies who will get their portion of assets recovered.
These are often used by investors who commit venture capital to a new business contract before investing in a new business. Because it’s important to understand that new businesses have around a 20% failure rate in their first year.
To protect themselves from huge losses, venture capitalists usually have a clause in their contracts when they finance these new companies to get paid first in the event of a bankruptcy or foreclosure.
Conclusion: Which Is Safest…Bonds or Stocks?
In conclusion, bonds are an important part of any portfolio. They just shouldn’t be the only part of it. The best way to plan for the future is to diversify your portfolio and have a mix of both stocks and bonds.
That will give you a good mix of risk and reward so you never have to worry if your stocks go down. As with anything, knowledge is power, so always make sure that you know what you’re doing before you do it. This is the only way to make sure you cover all of your bases.