Stocks Vs Bonds: One, The Other, Or Both?

Even in our stumbling economy, many people are still choosing to invest their money in ways likely to pay greater dividends than the simple savings account. Two popular investment choices today are stocks and bonds, but what’s the difference between them? Which is a safer choice?

Bonds

It’s a good idea to think of bonds along the same lines as giving a personal loan to a friend; instead, you’re loaning money to a corporation or other private entity. In exchange, the company agrees to pay you back, with interest. This promise is documented in the form of a bond.

Much like in the example of loaning a friend money, the general trustworthiness of a company is the basis of whether or not a bond is a good investment idea. Companies that have great credit ratings, have been around for a long time, or are considered “blue-chip” companies are obviously the safest choice to loan money to. However, taking a risk and loaning your money to a new, unproven company will likely result in a higher interest rate. As with most investments, the higher the risk you’re taking, the more reward you’re likely to reap if things work out.  As you might expect, it is much less risky to own a bond mutual fund than to purchase individual bonds.

Bonds are considered a less risky investment option compared to stocks because the amount your bond is worth is not affected by the financial success of a company (assuming the company survives to maturity and doesn’t default on the bond, of course). Whether the company loses or gains in the market, your bond will still be earning the same interest, and upon date of maturity, will be worth the same amount. The major risk with bonds is that the company will go out of business or file for bankruptcy, meaning you lose your principal investment, as well as any interest you were hoping to make. However, this happens rarely, and the risk is often mitigated by only investing in companies which appear financially stable.

Stocks

Stocks, on the other hand, are a much riskier investment. A stock represents an ownership share of a company; as a stockholder, you are buying a piece of that company, counting on the company’s future success. When the company does well, the value of the stock increases, and you make money. The complexity of the stock market, however, is that many factors other than a company’s success can affect the stock price. World events, economic growth and recession, products released by rival companies, and many other factors will affect a stock’s performance. Through purchasing the stock at a low price and selling it when it is at peak performance, investors have the potential for a huge return.  Large cap stocks are generally considered to be less risky than small cap stocks but also tend to have lower returns over the long run.  A wise investors owns both.

Looking at stocks vs bonds, both have their own unique risk and reward profiles. In order to maintain proper diversification, you absolutely must own both, although in what proportion depends on your own specific circumstances.  With a little research and making wise choices, the risk can be managed in a way that the investments are more likely to be profitable for you. No investment comes with a guarantee, but choosing which risks are most worth the potential reward is the key to success.