At Cedarstone we believe it is important for every investor to understand the fundamentals, including how securities work and what their relationships are to one another. Investing in the financial markets can be a complicated matter, but it is still important to understand how your money is invested. During crazy markets like we saw during 2020, an understanding of the fundamentals of investing can helps investors make sense market movements. With that in mind, here is a refresher on the differences between investing in stocks and investing in bonds.
The most important thing to remember about stocks is that they represent ownership. When you purchase a share of a company, you are purchasing a tiny slice of that company. In doing so, you participate in the financial successes and failures of the company. In the most basic sense, a stock investor gets to share in the profits of the company. The risk of owning a specific stock has a lot to do with the risks present for the specific company. A share in an older, well established company will be less risky than a share in a hot new startup which has a greater potential to fail. Of course, there are tradeoffs that come with taking on risk. The hot new startup knows that it’s a risky investment and consequently will offer higher return prospects to compensate for the greater risk. Owning stocks makes sense for individuals who are looking to grow their assets over a longer time-period.
The most important thing to remember about bonds is that they represent a loan. When you purchase a bond, you are in effect lending money to a company, municipality, or other organization. In return, that entity compensates you in the form of interest and then returns your money at the end of the bond agreement period (or term). Bonds are considered less risky because bonds are more predictable than stocks – the payments that you are eligible to receive are defined in the bond. Since bonds are more predictable than stocks, bonds are easier to price, and because they are easier to price, they experience less price fluctuation. Even in the event of bankruptcy, bonds are higher up in the capital structure, which means that bonds take priority over stocks in terms of who gets paid back with whatever money remains in the company. Owning bonds makes sense for individuals who want income, or who are looking to generate sufficient returns on their assets to fulfill a long-term goal, but who cannot afford to lose a significant portion of those assets.
One of the reasons investors are often encouraged to own both stocks and bonds in their portfolio is that the two types of assets typically function differently in different environments. Stocks tend to do better when economies are thriving, and companies are growing. Bonds tend to do better when economies are struggling, and investors are looking for a more predictable payment stream rather than long-term growth. These contrary risk-return profiles have traditionally made stocks and bonds complimentary such that when stocks have struggled, bonds have done well and vice versa.
If you would like to learn more about how we invest, we invite you to explore our insights or give us a call.
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