There are advantages and disadvantages to buying stocks instead of bonds. Understanding the difference between the two is key to making the right choice for your portfolio.
Let's start by taking a look at the key features of stocks and bonds.
Buying Stocks Instead of Bonds: An Overview
Stocks and bonds differ dramatically in their structures, payouts, returns, and risks.
The Pros and Cons Of Buying Stocks Instead Of Bonds
Stocks are a form of ownership. They represent participation in a company's growth. Generally, investors do not receive any promises about returns of the initial investment. The profitability of the investment depends almost entirely upon the rising stock price, which, at the most fundamental level, relates directly to the performance and growth (increasing profits) of the company.
- Stocks offer the potential for higher returns than bonds but also come with higher risks.
- Bonds generally offer fairly reliable returns and are better suited for risk-averse investors.
- For most investors, diversifying with a combination of stocks and bonds is the best option. Diversification helps mitigate risk.
A bond is a form of debt in which you are the lender instead of the borrower. Bonds are contractual loans made between investors and institutions that, in return for financing, will pay a premium for borrowing, known as a coupon.
Additionally, the investor receives the bond's face value at maturity. The guarantee of payback and all coupon payments relies solely on the ability of the borrower to generate enough cash flow to repay bondholders.
So which security is better? The answer is neither. Stocks and bonds both have their pros and cons, depending on what you are looking for.
Pros of Buying Stocks Instead of Bonds
Stocks have the potential to generate higher returns than bonds. Investors who are willing to take on greater risks than bondholders—and who would prefer the benefit of having partial ownership in a company and the unlimited potential of a rising stock price—would be better off investing in stocks.
By diversifying your investments and placing money into both stocks and bonds, you ensure some safety while leaving some opportunity for above-average returns in your stock investments.
Cons of Buying Stocks Instead of Bonds
In general, stocks are riskier than bonds. The disadvantage of stocks vs. bonds is that stocks are not guaranteed to return anything to the investor, while bonds generally offer fairly reliable returns through coupon payments. Thus, the possibility for high returns is greater with stocks, but so is the possibility of losing money.
Risk-averse investors looking for safety of capital—who prefer a known periodic payment structure (i.e., coupon payments) for a limited time frame—would be better off investing in bonds.