When it comes to investments, there are a lot of different options to choose from. Two of the most popular investment vehicles are stocks and bonds. While they may seem similar at first glance, there are some important differences between them. Today we will analyze the differences and similarities between bonds and stocks.
What are the similarities between bonds and stocks?
The most obvious similarity between stocks and bonds is that they are both types of investments. When you invest in a bond or stock, you are essentially lending money to a company or government entity.
In return for your investment, you will receive interest payments (in the case of bonds) or dividends (in the case of stocks). There are also stocks that do not pay dividends but still generate earnings that contribute to the value of the shareholder’s equity.
Another similarity between stocks and bonds is that they both come with some level of risk. When you invest in a bond, there is always the possibility that the issuer will default on their payments. Similarly, when you invest in a stock, there is always the chance that the value of the stock will go down.
You can also buy both of these types of investments through brokerages and other financial institutions. As an investor, you can hold both stocks and bonds in your portfolio.
What are the differences between bonds and stocks?
One of the biggest differences is that bonds are typically considered to be less risky than stocks. This is because bonds are backed by the full faith and credit of the issuing entity, whereas stocks are not.
Another key difference is that bonds typically have a fixed term, meaning that you will receive your interest payments for a set period of time. Stocks, on the other hand, do not have a fixed term.
This means that you could hold onto a stock for years or sell it as soon as its value goes up. Although you can earn passive income in the form of dividends, not all stocks pay dividends.
In contrast, most bonds make periodic interest payments. Dividend payments also can vary depending on the profitability of the company, whereas interest payments on bonds are fixed at the same rate.
With stocks, you own equity in a company. This means that you have voting rights and a say in how the company is run. With bonds, you are simply lending money to an entity and do not have any ownership rights.
You can vote as a citizen, but investing in government bonds won't give you a say in how the government is run, especially if you are investing in foreign sovereign bonds.
Finally, it’s important to note that bonds tend to be less volatile than stocks. This means that their value doesn’t fluctuate as much in response to changes in the market. However, this also means that bonds typically provide lower returns than stocks over the long run.
How are stocks and bonds similar?
As a review, they are alike in the sense that they are both investments, and they can both be bought and sold. They are also alike because they come with some level of risk. Both stocks and bonds can be a part of a well-diversified portfolio.
Similarities between bonds and stocks:
● Both are types of investments
● Both come with some level of risk
● You can buy both through brokerages and other financial institutions
Now that we have reviewed the similar characteristics of each, let's explore the risk similarities that these two investment options share.
Similar risks of stocks and bonds
While stocks and bonds share some characteristic similarities, they also come with similar risk profiles. For instance, both are subject to market risk, which is the chance that their value will go down due to changes in the overall economy.
For example, if there's a recession, the value of both stocks and bonds is likely to decline. Let's explore these similarities in more detail.
Management Risks
Stocks are subject to something called company risk, which is the chance that a specific company will run into trouble. This could be due to things like mismanagement, poor financial planning, or even fraud.
Bonds can also go through similar risks except the government might be the one that is in trouble instead of a company. This is called sovereign risk and it's the chance that a government will default on its bonds.
Examples of sovereign defaults happen more than you might think. Greece is a recent example. Argentina has also defaulted on its debts nine times since the country's inception. As you can see, countries share similar risks in terms of poor management and economic downturns.
Additionally, investors in corporate bonds can also face the risk that the company defaults on its debt.
Inflation Risks
In terms of similarities, both stocks and bonds are subject to inflation risk, which is the chance that your investment will lose value over time due to inflation. This is because when prices go up, the value of your money goes down.
For example, the real bond yield, which is the yield after inflation, was negative in Japan for over a decade. This means that investors in Japanese bonds were actually losing money after inflation.
Similarly, if a stock portfolio increases in value but the currency devalues, the portfolio's real return would be negative. For example, let's say that a stock portfolio has increased 5% but inflation is at 7%, the portfolio's real return would be negative.
Income investors are typically more worried about inflation risk than growth investors because they rely on their investments for income. Growth investors, on the other hand, are more focused on the appreciation of their investments.
Either way, a $500 monthly dividend payment might seem incredible today, but the purchasing power of that sum could be very different in 20 years.
Political Risks
Another similarity between stocks and bonds is that they are both subject to political risk. This is the chance that a decision made by the government will hurt your investment.
For example, if a country decides to ban or legalize an industry, the stocks of companies in that industry will likely go down. This happened recently with the vaping industry in the United States.
In 2020, the Trump administration decided to ban flavored e-cigarettes. Announcements like this from political figures can cause entire industries to struggle. The Biden administration is causing similar effects with their viewpoints on sustainable energy.
The legalization of Cannabis in Canada also caused stocks in this industry to soar. Political decisions and regulations can have a big effect on investments, so it's important to be aware of this risk.
Bonds are also subject to political risk. For example, if a country decides to default on its debt, the bondholders will likely lose money. This happened recently in Venezuela and Argentina. The government decided to stop making payments on their bonds, which caused the value of the bonds to go down.
Investors need to be aware of these risks before investing in any stock or bond. They should also have a plan for what to do if these risks come to fruition.
Conclusion
There are a few key similarities between bonds and stocks, but there are also some important differences that investors need to be aware of. The main difference between stocks and bonds is that stocks represent ownership in a company, while bonds are simply loans.
Investors should always plan for risks and understand the potential implications before making any decisions. Each investment type and individual investment within that typically come with its own set of risks. By being aware of these risks, investors can make more informed decisions and avoid potential losses.
