Step 49: The Difference between Shares and Bonds

Step 49 of the 100 steps to Financial Independence: The Difference between Shares and Bonds
Step 49: The Difference between Shares and Bonds

Stock markets have a vast selection of stocks and bonds that can be invested in and before deciding what to invest in, understanding the main differences between stocks and bonds well is absolutely key if you consider getting in the stock market. Investors can decide whether they want to invest in just shares, just bonds or whether to create their own mix of stocks and bonds. With time, many furthermore decide to slowly reallocate their investments, so even if you start with a certain percentage shares and bonds, this needn’t stay as such for the rest of your investment life.

Here we’ll look at the main differences between shares and bonds from an investor’s point of view and how they both offer different advantages and disadvantages.

Volatility

  • Share prices vary more day-to-day but also over long periods of time: their value can increase or decrease fast.
  • Bonds are generally more price solid and fluctuate less over time and at a much slower pace than shares.

Long term strategy

  • Shares are generally more “offensive” and are seen as vehicles to build wealth. Due to their prices fluctuating more than those of bonds, shares have – far more than bonds – the potential to increase an investor’s capital. Obviously shares also have the potential to lose a lot of their value, meaning the investor has a bigger chance of losing more money.
  • Bonds are more “defensive” since their prices don’t fluctuate as much as shares and are therefore more seen as vehicles that maintain wealth. Bonds won’t normally make the investor big bucks, although when seen over long periods of time, they do normally increase an investor’s capital, performing better than simply beating inflation rates, but they do this at slower pace than shares. At the same time, they of course also won’t lose a whole lot of value, or at least this risk is lower than with shares. Investing in bonds is still no guarantee however, they can still drop in price significantly over time.

Life span

  • Shares have no life span and continue to exist unless the company goes bust or is taken over and absorbed by another company. Otherwise shares will continue to live on, giving the owners dividends as long as profits are good for pretty much as long as the company lasts.
  • Bonds in contrast, have a set lifespan, and you will know the end date of its existence when you purchase a bond, which is the moment you will be getting the original face value of the bond (the original loan) back (all going well of course).

Payments

  • Owners of shares are paid out dividends, i.e. profits shared amongst the owners of a business, and dividend payments go up and down depending on the profits of the company as well as future investments and expansion plans they have, loan re-payments (including bonds) and other allocations for the money made. As an investor, you will never know the amount of dividend paid out until the end of a fiscal year when companies present their profit numbers. Companies can however release a profit warning ahead of time, to warn investors that profits might be less than expected.
  • Bonds in contrast give interest which is a set rate for the duration of the bond’s existence. Interest can be paid annually or more frequently.
  • Both interest and dividend payments can often be reinvested again automatically, either in the same or a different company, meaning that like with savings, both bonds and shares can also benefit from the effects of compound interest with time. Of course there’s no reason why either interest or dividend couldn’t just be taken out as an extra side income :).

Ownership

  • Bonds don’t give you a part of the company, it is nothing more than a loan. This means you have no voting rights or a say in the company, you simply lend some money that you should receive back at a certain point in the future.
  • Shares do give you a part of the company and allow you to have a say in the company by being able to attend and vote at the annual or extraordinary company meetings. This is not a requirement however and the majority of small investors never attend a meeting in their life.

The stock market is complex and these are only some of the differences that exist between stocks and bonds. These are guidelines only, there are some exceptions with certain bonds and shares (there are some bonds with no fixed end date for example), but let’s not complicate things further at this stage.

Step 49 – The Difference between Shares and Bonds – in detail:

As we have mentioned above, investors can decide on their own mix of stocks and bonds, depending on their preferences, reasons for investing and even age. In this action plan, we are going to look at how different mixes affect performance (returns) as well as risks (possible losses).

  • Type in example portfolios investing into your search engine, and you will likely get different example portfolios of stocks and bonds allocations. Compare various graphs on the following two factors:
    • assets allocation (bonds and shares): what percentage of the portfolio is made up by shares and bonds respectively.
    • performance – i.e. the return on investment, often indicated by a percentage. Look at this over longer periods of time, for example over 5 years, 10 years and more.
    • risk – i.e. the potential losses over time. Stocks can lose a lot of money in short periods of time, so the short-term losses can be substantial, though also often times if holding on to stocks the risks over time get leveled out.
  • Example portfolios are often recommended based on two factors: the investor’s age (the older you are, the less risk you often want to run – we will look at this further ahead) as well as an investor’s risk tolerance, i.e. how comfortable you are with the level of risk. Do an internet search typing in investing risk tolerance quiz and you’ll likely get several options for questionnaires to fill in and find out how much risk you are comfortable with. Complete a few just to get an idea of your personal risk tolerance.

I hope that clarified stocks and bonds a little more. Now that you know the basics of the stock markets, in the next few steps we will be looking at how investing really works and what to do when markets go up or down.

Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.

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