Stocks vs Bonds: Understand The Differences And Risks In 5 minutes or less
Stocks vs Bonds

Stocks vs Bonds: Understand The Differences And Risks In 5 minutes or less

I am sure you have heard about stocks and bonds unless you have been living under a rock. It has to literally be a super isolated rock with no humans around at all. In the world of investment, it is impossible to navigate through without understanding this fundamental concept of stocks vs bonds.

Both stock and bonds are powerful forms of investments which allow you to invest your money in a particular company or corporation in hope of a future profit. Perhaps, more than just a little profit. After all, Warren Buffet became one of the richest men in the world with these investment vehicles. He is now worth a whooping 81 Billion dollars at the time of this writing. Here is the live net-worth of Warren Buffet.

The questions many people have are

How exactly do they work? And

What are the differences between the two?

Keep reading to get the in-depth analysis of stock vs bonds. This would help you decide which vehicle is right for you. You might even be convinced to mix the two.  

 


What are stocks?

Stocks represent ownership stake in a company. In easy language, when you buy a stock, you get a share or shares of a company. These shares give you part ownership of that company.  You, the owner of the share is now referred to as a share-holder.

What should be obvious is that your stake or shares in that company is directly proportional to the amount of shares you own as an investor. You eat what you kill, so to speak. If you want to own more of the company, buy more shares.

A bonus is that with shares, you get voting rights in the company. Go ahead, exercise your power

Stock comes in what we call capitalization rate. You hear the word mid-caps, small caps, and large caps. 

More information about that below .

Don’t be confused when you hear the word, “cap” , just know its not the hat for fashion but a shorthand for capitalization rate.

 

To be a better investor, you need to know the rule of 72 to know when you will double your money

 

What is Market Capitalization 

Market capitalization is the total dollar market value of a company’s outstanding shares. You can calculate this by multiplying a company’s outstanding shares by the current market price of one share.

For example

Consider Dr Breathe Easy Finance as a company (Don’t despise little beginnings ok)

Value of share = $10

Total outstanding shares = 100 million

Market capitalization =  $10 x $100,000,000 = $1 billion.

 

To be a great investor, you must learn the fundamentals of stocks vs bonds
Market Cap in short. Stock vs bonds

 

Knowing about cap rate allows you to know the risk involved and the potential return on your investments. Although there are nano caps, micro caps and mega caps, the three major capitalization rate that matters in stocks are the small cap, mid cap and large cap.

 

What are Small Cap Funds

Small cap funds typically comprise of companies with market caps of less than $2 billion.  As you might have suspected, these are relatively young or new companies. They tend to focus a lot on growth and thus the growth potential is high. The word here is “potential”.  In general, the higher the reward, the higher the risk. So take heed.

 

What are Mid Cap Funds

Mid cap funds typically comprise of companies with market caps of $2 billion to $10 billion.

 

What are Large Cap Funds

Large cap funds typically comprise of companies with market caps of $10 billion or more. These are more stable companies. They are not in the business of trying to double their capital in few years. Their priority is to maintain stability and dominance. They take less risk at this stage.

 

To get started with investing, often times, 401k is the way to start if you live in USA. Check out all you need to know about 401k. The most comprehensive guide on the subject.

 

The reason I went through the above definitions is that, the smaller the caps, the more volatile the stock is in general and the larger the cap, the more stable it is.

On the flip side, if I am aiming for higher return that beat the index, a.k.a S&P 500, then I’ll edge my bet on the small cap funds.

 

Stocks, unlike bonds, tend to fluctuate in value and are traded in the stock market. Stocks can be traded in the stock market within any time frame you chose. You can day trade, do short term trade or long term trade. So far, we only do the long term investment approach with index funds.

The worth of a particular stock is highly dependent on the company’s performance.  If the company is doing well, the value of the stock increases. The reverse is also true. If the company is struggling, the value of the stock plummets.

Because of the volatility of stocks, it is thought to be riskier than investing in bonds.

 

If you are looking for how to start investing, check out our ultra beginners ways to start investing

What are Bonds

The best way to visualize bond is to think bonds as a loan or debt that has to be paid back. When you invest in bonds, you are basically loaning your cash to that company or corporation of your choice. Government issues bonds too.  That company, in turn, will give you a receipt for your loan, along with a promise of interest, in the form of a bond.

 

To be wealthy, you have to understand the concept of time value of money 

 

You can buy bonds in the open market. However, nowadays, you can just buy them through investment platforms like Vanguard.

The value of bonds can also fluctuate based on the interest rate of the economy. The bond value fluctuate based on the interest rate of the general economy.

For instance, if you have a bond which pays the interest of 4% interest yearly, you can sell it at a higher face value provided the general interest rate is below 4%. But, if the rate of interest rises to 5% for example, the bond, will be sold at lesser price.  

 

Unlike stocks, you do not own part of the company. This could be a curse and a blessing.  A curse, because you cannot vote on the affairs of the company.  You will also not be directly benefit from the success of the company or its profits. 

A blessing , because, if the company goes down, you are more likely to get your money back than a share holder.  Your return rate is the same – the percentage of the original offer of the bond.  This percentage is called the coupon rate. 

 

Check out our post about pretax vs after tax investment comparison with awesome example and analysis

 

Bonds have maturity dates. And different bonds have different maturity dates.

What does that mean?

Once the maturity date of bond arrives, the principal amount paid for that bond is returned to the investor. 

 

With bonds, the highest risk is losing your principal investment amount. You can mitigate this risk by doing your due diligence and researching the company before investing.

 

The companies that have more credit worthiness are generally safer investments when it comes to bonds.  The best example of a “safe” bond is the Government bond. Just remember, if you play it too safe, then you must be ready to accept a lower coupon rate.   

Just like any investment venture, there is a trade-off between the risks and the possible rewards of bonds.

 

Check out why making your first million is the hardest, and how long it will take you to become a millionaire by just investing in Roth IRA

 

Conclusion

Both stocks and bonds can be profitable investments.  However, it is important to realize that they both have certain amount of risks to them. Stocks tend to be riskier, but with high reward depending on how risky you want to go. Bonds are a little bit safer, but with mediocre reward. Be aware of the risks and take steps to mitigate your risks.  The key to effective investing is to do your due diligence and take the minimum amount of risk you can afford. 

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