The Difference Between Stocks And Bonds

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Do you know the difference between these two asset classes?

We’re going to clear the air about some investment basics: how to define stocks and bonds, what are their benefits, and what are their drawbacks.

It is important to any investor to have the correct asset allocation of stocks and bonds in their portfolio. And to make the right decisions, you need to know exactly what each type of investment offers.

Stocks vs Bonds: Defined

Stock – the general definition is that a stock represents a share or portion of a corporation. When you own stock in a company, you are technically a part owner of that company. Ownership size can be large or small depending on the number of shares you purchase.

Let’s say a technology company needs to raise money, they can either borrow it or they can sell a stake in their company to the public. When they decide to sell part of their company, they do this by issuing shares of stock.

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The value of these technology company stocks reflect it’s periods of profit and loss. The goal is to buy a certain number of shares at a lower price than what you will eventually sell them for. However, you have no real control over the price of the stock. The risk you face is that the price of the stock may drop lower than the price you paid for it, ending up in a loss of money for you the stockholder.

Bond – this is essentially a loan that an individual makes to a company. The loan agreement between the individual and the company includes repayment with a preset interest rate. Instead of selling part of the company to the public, a company can issue bonds at various interest rates and sell them to the public. This way the company can raise money without losing any ownership.

Investors make money because they are paid back the amount they loaned to the company plus the interest owed to them. Think of a bondholder as holding an IOU + interest.

Investing in Stocks and Bonds

Maybe the most important difference between stocks and bonds is that stocks potentially have a higher potential for return on investment. That’s a fancy way of saying that a person MIGHT make more money when purchasing stocks, but the risk is greater than purchasing bonds.

Theoretically, stocks have an unlimited chance for appreciation. There is no set ceiling for how much they can earn (again, all in theory). This is why they are found in heavy doses for those doing aggressive investing. Bonds on the other hand have a set interest rate and therefore set amount of return on investment.

Bonds do have a chance to sell at a premium before they mature, but they have much less potential for appreciation.

Both stocks and bonds have their risks. Although stocks theoretically have no ceiling, they definitely have a bottom. Stocks can eventually become worthless if things get bad enough for the company.

With bonds there is credit risk on the part of the company issuing the bonds. This means the issuing company may have trouble making it’s repayments on time, or at all (defaulting on the loan).

Because of the different risks and potential gains and losses, it’s important for any investor to have a healthy amount of various types of investments. This is called diversifying, and it’s a key component in meeting your investment goals.

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