What Are The Differences Between Stocks And Bonds?
There is a significant difference between stocks and bonds and how they function in the marketplace. While they are both used to raise capital in a corporation, there are different regulatory and accounting requirements. Fundamentally stocks allow investors to own a part of the company while bonds are a debt which pays interest payments to bondholders. Understanding the difference between the two and recognizing their relation to market trends is important because many small investors will purchase these types of financial instruments blindly and then get burned when something unexpected happens.
Stocks
When stock is issued in a company during an initial public offering, also known as IPO, it allows individual and institutional investors to purchase shares of ownership in that organization. There are different SEC requirements depending on how many shares are owned but normally when an investor buys or sells more than 5% they must make a formal disclosure. Investors like to own stock because of the upside potential in the underlying stock increasing in price. For example, when purchasing 100 shares of IBM at $150 a share an investor will own $15,000 worth of IBM stock. The hope is that the stock price will increase from $150 a share to something higher in the future. If this happens they can choose to sell their shares back on the open market and make a profit.
As a stockholder, investors have the ability to vote their shares of stock during annual shareholder meetings. Voting normally entails selecting board members and an accounting firm. Important issues are often presented by shareholders if the perception is that the company is not acting in their best interest. Owning shares will sometimes result in dividend payments but only if the company actually issues a dividend. Some companies use excess cash to purchase competitors or expand operations and will refrain from paying a dividend.
Bonds
Companies will sometimes raise capital by some other means than issuing additional shares of stock. One of the most common ways is to issue debt in the form of bonds which allows investors to receive an interest payment also known as a coupon payment. When a bond is purchased for its face amount the bond issuer agrees to pay the bond holder a fixed amount of interest for a specific period of time. Once this time has passed the bondholder is paid the face amount of the bond and the transaction is closed. Most bondholders however, never keep a 10 or 30 year bond until maturity and they are inevitably sold back on the open market.
The primary risk of owning bonds is that when they're sold on the open market the face value may have decreased in the interim. Bond values move in an inverse relationship to interest rates. If a $10,000 10 year bond is purchased with a coupon rate of 5% and inflation is currently 2% then the bondholder would receive 5% for 10 years and then get the face value back. Unfortunately, if the bond is sold after four years and interest rates have been increased dramatically to combat inflation the face value of the bond will decrease. It is very dangerous to own bonds or bond mutual funds in a time of increasing interest rates.
Summary
Stocks represent an equity ownership in a company and come with voting privileges while bonds represent debt in a company which allows a consistent interest payment but no actual ownership. Stocks are good to own if a company is experiencing annual growth in sales and net income and bonds are good own in times of decreasing interest rates or if an investor carries the bond to maturity collecting a high coupon rate. Once you understand the differences between stocks and bonds investing in either becomes much easier and entails less risk. However, with any investment risk will always be present so speak with a financial advisor or investment professional if you have additional questions.
