What is the Difference Between Stocks and Bonds?

What is the Difference Between Stocks and Bonds?

June 25, 2018

After my Undergraduate Graduation, I was having a great time chatting with some of my fellow business major alumni. We were talking about what we learned (or didn't learn). One person joked that even after receiving his degree, he had only a vague understanding of the difference between stocks and bonds. He knew that they were both a type of investment, and that bonds have less risk than stocks, but he did not understand why.

A bit of nervous laughter ensued, and we all changed the subject. The fact that even a business major did not understand the concrete differences between a stock and a bond means that people who didn't pursue a busines degree probably have very little info on the subject.

MDAS to the rescue! For qualification purposes, in my previous work experience I have been involved in investing very large sums of money (in the tens of billions) in both stocks and bonds. I worked on a team that invested money for very large pension funds, universities (even the university that I attended), and wealthy individuals. I love investing and want to bring the skills and basic understanding necessary to invest to everyone I possibly can.

With that being said, lets get down to it. What is the difference between Stocks and Bonds? At the most fundamental level, they are two completely different types of investment.

Bond - A claim on debt

Stock - A piece of ownership (Also known as Equity)

So when you are investing in bonds, you are lending money to someone, some company, or some government, and they are promising to pay you back with interest. The risk of lending someone money is pretty clear: they might not pay you back. That same principle holds true no matter how much money is in the picture, whether you are lending $5 to a friend or $5 Million to Apple Inc. Another very important distinction is that a bond has a set amount of time you must hold it for, indicated by the "maturity date". An Apple bond maturing in 2048 with a 4% "coupon" has a 20 year life, and will pay you 4% per year on your invested amount of money as long as Apple is a healthy company and makes its payments. So if you purchase $1,000 of 4% Coupon AAPL 2048 bonds, you will be giving Apple Inc. $1,000 and they are promising to pay you $40/Year for the next 20 years. At the maturity date, AAPL will also return your initial $1,000 to you.

On the flip side, when investing in Stocks (Equities) you are buying a piece of ownership in the company. If the company does well, makes increasing amounts of money and continues to grow, the value of your stock will increase due to supply and demand. More people will want the stock you own, and they will be willing to pay higher prices for it. When a company is doing very well financially and its stock price is stagnant or decreasing, this is a golden opportunity to buy a piece of the company for a bargain. The downside to owning stock is that even a small decrease in the financial health of a company can have a large negative effect on its stock price. (This is not evident with bonds, aslong as the company continues to make the bond payments.) The benefit of owning stocks is that they have had a historical return that is much higher than bonds. Take AAPL stock for example, with an AVERAGE return of over 30%/Year from 1981 to 2017.

When investing in Bonds, you make your money through interest payments which vary depending on the financial health of the institution you are lending to. Investing in Apple Inc. will bring you a lower return than investing in Motorolla, but the risk is also substantially lower because Apple is many times more profitable.

When investing in stocks, you make your money through the appreciation of the stock's price as well as potential dividend payments. A dividend is a cash payment that the company pays you for holding a stock. Not all companies pay a dividend, but when they do it is an added benefit of holding the stock.

So should you invest in stocks or bonds? Well, bonds are usually the safer investment. If you purchase an AAPL bond, there is a very low probability that the company will default on their payments, leaving you stranded. This is paired with a lower expected return of 4% over the next 20 years versus a potential return of 30%+ from holding a piece of ownership through stock. Specifics aside, this theme that bonds are safer than stocks holds through no matter what the underlying company is.

There is always a benefit of having safety in your portfolio. When all stock prices fell during the financial crisis, high quality bonds continued to pay the bondholders. By holding bonds, your portfolio saw a continued stream of income while times were tough. You could have used the income from holding bonds to buy stocks at their lowest prices. To give you a concrete answer to "Should you invest in bonds", here is a solid principle to live by:

The rough % of your account that you should allocate to stocks is (120-(Your Age))

If you are 20 years old and just getting started investing, you should be 100% in stocks. At 30, decrease your stock investment to 90% and invest 10% in bonds to smooth the ride during tough times. I know I used Apple Inc. as a specific stock/bond example, but I highly recommend investing using "Exchange Traded Funds" or "Mutual Funds" that invest in a diversified portfolio of companies, reducing the risk you face by investing everything in one company.

A good example of a diversified stock ETF is ticker "VOO", Vanguard's S&P500 fund which investest in the largest 500 companies in the USA. A great diversified bond fund is "BND", Vanguard's Total Bond ETF. If you would like to get started investing now, you can purchase these ETFs for free after you create an account with "Robinhood", an online investment brokerage house. Use THIS link to get a free stock just for signing up! I also have links to a few books you might like to read on my Home Page!

MDAS

If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!

P.S. New blog posts coming your way every Monday!

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