Author: Jázmin Lászik
Publication date: 26.10.2023
The world of investing can be complex and difficult to understand for people who just started putting their money to work. Every individual can find an asset that suits them the best.
Are you a risk taker aiming for high profits in a short amount of time with potential big losses? Or a long-term investor who is patient and waits a long time for lesser profit but without the risk? Either you are, there’s potentially an asset that suits your preferences. Let’s take a look at different kinds of stocks and bonds.
What is a stock?
A stock is an ownership. You own a part of the company that issued the stock to finance growth and expansion. Usually, companies have millions of shares so your part in the company is very little. This means that you’re entitled to the company’s assets and profits. Of course, a big part of that profit is usually reinvested into the company (upgrading, buying assets, expanding) and another part is paid back as dividends.
The most well-known stocks are common stocks and preferred stocks. With Common Stocks, you get a vote on the company’s future. You are entitled to the profits and you’re one of the owners of the company. Preferred Stockholders are also owners but they’ll get paid fixed guaranteed dividends if the business goes bankrupt.
How do you make money with stocks?
You can earn money in 2 ways when buying stocks. First, you can earn money by holding the stock. The corporation pays a portion of its profit to the shareholders annually or quarterly based on what the interest rate is. This is called the Dividend.
The other way is to sell the stock. The market value of the stock can increase or decrease over time. If you bought a stock for $100 a year ago and now it’s worth $150 you can realize $50 as profit but only when you sell the stock. Until then it’s paper gains.
What are Bonds?
Bonds are loans issued by companies or governments to finance their expansion and projects. They borrow money from you with an end date when they’ll pay back the full price.
Bonds are usually seen as a safer investment opportunity than stocks because of the high probability of payback at the end. This of course depends on how successful and reliable the company is that you’re lending money to.
How to make money with Bonds?
Bonds usually have a face value, the amount of money that they’re going to pay you back at the maturity date. They also have an interest rate called a coupon rate.
Every year they pay you a Coupon until the bond matures. Coupon=Face value x Coupon rate. For example, you buy a bond for $1,000 with a Face Value of $1,000 and a Coupon rate of 5%. The bond matures in 10 years. Every year the company’s going to pay you $1,000 x 5% = $50. After 10 years they pay you back the $1,000 you lent them.
Everything has a risk
Investing in any kind of asset is risky. The only difference is the volume and the probability of risks. Both stocks and bonds have the risk of not being able to pay back their holders and go bankrupt/default.
Stocks have many different kinds of risks. Market risk affects entire markets due to unforeseen events. For example, when the Covid pandemic hit. Every company has its own Specific risks as well like their CEOs, incomes, and internal issues. And also when the interest rate changes that affects the stock prices too. When the interest rate decreases stocks tend to go up.
Bonds are usually seen as a less risky asset. This is because there’s a fixed face value the issuer is going to pay back assuming the issuer does not default. Credit quality can help you decide if there’s a possibility of default. You can check a bond’s credit quality by looking at its ratings. Their ratings are given by rating agencies, such as Standard & Poor’s, Moody’s and Fitch.
Bonds with an “AAA” to “BBB” or from “Aaa” to “Baa” rating are less likely to default and they offer lower interest rates. Bonds with a score of “BB” / “Ba” or lower are considered “junk” bonds. Therefore, they are riskier but they offer higher yields because the issuing company is in a weaker financial position.
Should I invest in Stocks or Bonds?
Bonds and Stocks both can be beneficial in building a strong investing portfolio. Stocks are better for a shorter term, more riskier but preferably higher profit investment. Bonds are long-term investments with smaller profits but much lower risk. When building a portfolio, including both of them can be a good strategy.
The picture presents the suggested percentage of different assets in different portfolios. Equities = Stocks.