05 April 2021
Financial markets can sometimes be like playing at an online casino – winning requires luck, not just knowledge. Two basic options will come across to anyone new to this market: stocks and bonds. There is an endless debate about which of these you should choose. Some experts say you should choose stocks, others say bonds. So, which one of these is correct? As a new player in the financial markets, which one should you focus on? We answer all these questions below.
First Things First: What Are Stocks and Bonds?
Let’s start with the basics first because choosing between bonds and stocks wouldn’t be right without knowing what they are. Both of them are financial assets and can be purchased by investors. However, they work completely differently.
Stocks: These are assets that allow you to obtain partial ownership in a particular company. By purchasing a stock, you also buy a small portion of a company. For this reason, they are also known as “shares”. Let’s give a simple example. Imagine a company has 1,000 stocks, and each is worth 50 USD. You buy 10 stocks in total – you now own 1% of that company. Therefore, if the company grows and makes more money, the value of the stocks you have will increase. The stocks you buy by paying 500 USD may reach 50,000 USD in value a year later. (Of course, the opposite is also true, the company may lose value, and stock values may also decrease, in which case you will be at a loss.)
Bonds: Bonds are loans you give to a company or government. They do not allow you to obtain any ownership. Imagine you are using a loan from the bank: the bank will also charge interest when collecting your debt. However, just because it gave you some money does not mean it has any rights over you. Bonds are like this: companies and governments borrow from investors instead of going to banks to generate income and declare that they will repay at a certain interest rate within a specified period. Payment periods are usually quite long. For example, a government bond can be paid back within 10 years at an annual interest rate of 2%. This means that if you buy such a bond of 2,500 USD, the debt will be fully repaid after 10 years, and you will receive 50 USD interest income every year. Your total income will be 3,000 USD (2,500 USD principal debt + 500 USD interest income). Once again, the payment period and the interest amount are highly variable: it is possible to find 30-year bonds as well as several-day bonds.
So, Which One Is Better?
One thing is clear from the explanations we have made so far: stocks are an investment that is riskier compared to bonds. When you buy a bond, you know in advance when it will be paid back and how much you will earn. These numbers do not change. You will continue to earn the same income even in an economic crisis. There is no such guarantee in stocks: you can win a lot or lose a lot in a short time. It all depends on how well you choose. And even if you make the right choices, an economic crisis can turn all your plans upside down.
Still, stocks have an incredible profit potential. Stories of people who started with $ 100 and earned $ 100,000 a few months later are always sourced from stocks. It is not possible to make this level of profit with bonds. So, bonds are suitable for investors who are risk-averse and want to generate low but stable income over the long term. Stocks, on the other hand, will be a better choice for investors who are not afraid of high risks and want to make higher income.
Besides this basic difference, it is possible to list other advantages and disadvantages of stocks and bonds as follows:
- Stocks are a liquid asset. It is possible to sell or buy new ones at any time. Stock markets work this way too: you sell when stock prices fall, you hold when stock prices rise. In other words, you can cash out stocks at any time. Bonds are not like this: by purchasing a bond, you sign a contract, and you cannot redeem the bond before the deadline specified in the contract expires.
- Stocks require more work. When you own stock, you cannot make money just by holding it. You must keep track of stock prices and sell (or buy new ones) as needed – only then can you get Bonds are, on the other hand, a “take-and-forget” investment: you get your interest income when the time comes, and you don’t have to follow anything.
- Stocks really pay more. We know we said this above, but it is worth repeating one more time. It is possible to make a real profit for your hard work. Statistics show that the 10-year average return of stocks is 10.65%. This value is only 3.92% for bonds.
Low but stable income – high but risky income: this is what you should consider when deciding between stocks and bonds. As always, the decision is yours, but if your goal is to plan your retirement, bonds would be a much better choice. If you are young and like the possibility of earning enough money to own a yacht, you should choose stocks.