Stocks and bonds: 5 main differences and investment tips

The distinction between the stock and bond markets can help investors properly allocate their funds based on their goals and risk tolerance. After all, a diversified portfolio is usually recommended by market professionals on the same logic as "don't put all your eggs in one basket." This is because investing in a variety of financial instruments that react differently to the same event can help smooth out risk-adjusted returns, rather than depending solely on the performance of a single asset or asset class.

In this article, we take a closer look at the differences between stocks and bonds:

A basic overview of these two types of investments

Five key differences

How to invest in stocks and bonds

Frequently asked questions about stocks and bonds

Stocks and Bonds: Overview

Stocks and bonds are two different ways to raise capital to operate or expand a business. To begin comparing these two investment options, it's important to first understand their basic concepts and definitions.

What is a stock?

A stock is a share/ownership in a company that is bought and/or sold on a stock exchange. Buying shares is associated with a potentially higher future share price and dividends.

What are bonds?

Bonds are issued by governments and corporations to raise capital, and these instruments are traded over-the-counter. When an investor buys a bond, they are essentially making a loan to the issuer, who in turn agrees to repay the face value of the loan on a certain date along with regular interest payments called coupons (% of face value) at predetermined intervals.

Top 5 differences between stocks and bonds

1. How they are traded

While stocks are traded on a centralized exchange such as NYSE or LSE, bonds are mostly traded over-the-counter, which means there is no official exchange, but these instruments are traded and negotiated between parties. Therefore, the bond market is considered less transparent than the stock market because buy/sell orders are not visible to all market participants to the same extent as is usually the case with stocks.

2. Ownership

Stocks represent ownership of a listed company, while bonds are considered a debt instrument. That is, investors in bonds are repaid the full amount of the original principal, except in the rare event that the bond defaults.

3- Exposure for investors

Stocks provide an opportunity to invest in various sectors of the economy. However, this generally excludes governments, although stocks can be affected by government decisions. Bonds provide investors with the opportunity to invest in governments (government bonds), corporations (corporate bonds), and financial organizations (financial institution bonds).

4. investment risk

Historically, bonds have been considered a less risky investment due to their low default rate and guaranteed interest and principal repayment. Stocks, on the other hand, do not provide a defined income stream. This is not to say that stocks are always riskier than bonds, as corporate bonds, especially high-yield or "junk" bonds, can also be risky. Keep reading to learn more about the risks associated with investing in stocks and bonds.

5. Yield

Bonds provide investors with a fairly certain return through interest payments, which often attracts risk-averse investors. Stocks can offer more income through dividend payments and share price growth, but these dividends are not always guaranteed. This is because companies are not obliged to pay dividends to shareholders and can stop or reduce dividend payments at any time.

How to invest in stocks and bonds

Stocks and bonds can be accessed through a variety of ways. Financial markets have become so sophisticated that investors are spoiled for choice; they have the opportunity to invest in specific instruments that meet their financial goals and budgetary constraints.

Investing in stocks

Physical dealing in stocks: Stocks can be invested in through physical stock dealing, which allows investors to purchase stocks in the hope that stock prices will rise, after which they can be sold at a profit (or at a loss if stock prices have fallen). This type of investing does not have leverage, which can help limit downside risk.

Leveraged Stock Trading: Involves trading stocks using leveraged or leveraged instruments, such as CFDs or leveraged ETFs. These instruments allow traders to leverage their funds many times over. This comes with a risk that must be fully evaluated before engaging in this type of trading. Traders seek to profit from changes in the price of a stock and can trade both long and short positions, which is different from trading physical stocks. Leverage amplifies returns both positively and negatively.

Stock ETFs and mutual funds: Give traders exposure to a variety of stocks through both types of investments, offering an element of diversification not normally available in just one stock or investment. Actively managed mutual funds give managers the ability to pick and change stocks as they see fit, while many passive funds or passive ETFs allocate investments to each other and track their performance.

Investing in bonds

OTC Bonds: Bonds are mostly traded over-the-counter, which means that they can be accessed through a broker, similar to a stockbroker. There are bonds that can be purchased directly from the government, such as US Treasury bonds, but many banks also offer government bonds. These bonds cannot be traded, so they are only available for purchase.

Leveraged bond trading: Many brokers offer treasury bonds for leveraged trading. These vary from broker to broker. This is mainly for government bonds, such as US Treasuries, rather than corporate or municipal bonds. This type of trading is based on the change in the price of the bond and can be either long or short.

ETFs and bond mutual funds: These are similar to stock ETFs and stock mutual funds. The principle of passive (ETFs) and active (mutual funds) management of portfolio components remains the same.

Before investing in stocks or bonds, you should research brokerage and trading commissions. This part of the investment process is often overlooked. Make sure you find a reputable broker with transparent fees.

When it comes to leveraged products, the risks are much higher and there are more complexities behind the trading fees and commissions. Reputable brokers usually have a special page with a description of fees.

Stocks vs. bonds: Summary

There are several differences between stocks and bonds, and the choice of investment depends solely on risk appetite and financial constraints. As a general rule, investors who are risk averse should lean toward a portfolio with more bonds, while risk-seeking individuals prefer stocks. Leverage changes this viewpoint because leveraged trading generally suits risk-seeking investors, while risk-averse investors tend to stay away from derivatives trading.

When investors understand their financial goals and budgetary constraints, they can get a clearer picture of what types of investment instruments appeal to them.