Stocks and bonds are ways that companies raise money for general operations. Companies sell both stocks and bonds to investors, who hope to profit from either an increase in value or through interest or dividend payments. Companies use the money they raise through the sale of stocks and bonds to fund general corporate purposes such as opening more stores or conducting additional research and product development.
As an investor, it's important to understand just what stocks and bonds are and how they can generate profits. It's also important to understand the risks involved in investing as well as how you can expect stocks and bonds to react in various market scenarios.
Stocks and Bonds Definition
Stocks represent actual physical ownership of public companies. As a shareholder, you participate in the gains and losses of the company, the same as every other shareholder. When the stock price gains 5 percent, your holdings increase in value by the same 5 percent; when the stock goes down, the opposite is true.
Bonds, rather than representing an ownership stake in a company, are essentially loans. When you buy a bond, you are giving a company money in exchange for the promise of regular interest payments and the return of your invested capital at some agreed-upon future date.
Thus, bonds are typically regarded as income investments, whereas stocks are generally referred to as growth investments, although there is some level of overlap.
Volatility Differences Between Stocks and Bonds
Stocks, in a general sense, are much more volatile than bonds. Stock prices can routinely go up or down in value by 2 or 3 percent in a single day, and often move by 10 percent, 20 percent or even 100 percent over the course of a single year.
Bonds, on the other hand, may not change price at all on any given day, and may only move by a few percentage points over the course of a year.
What Are Stock Quotes?
In the information age, it's hard to get away from stock quotes. If you open a web browser, you may see the daily stock market results scrolling across your home page. If you're watching the local news, or even just flipping channels on your television, you're likely to come across some type of stock market update.
With this type of information saturation, it can be easy to think of "stocks" and "the stock market" as nebulous numbers that magically create and destroy wealth. To the casual observer, stock quotes can seem like a game, or even a gamble. As with many things, however, the reality of what stocks are is quite different.
When you buy 100 shares of Apple, for example, you actually become a part-owner of the company. You won't have much control – as of 2019, Apple has about 4.75 billion shares outstanding – meaning your 100 shares represent an extremely tiny percentage of ownership in the company. But each individual share you own carries the same level of control as each individual share that a billionaire like Warren Buffet owns.
What Moves Stock Prices?
A few factors come into play when it comes to stock price movements, but they can be distilled down to one concept: supply and demand. When more people want to buy a stock than sell it, the price goes up; when more people want to sell a stock than buy it, the price goes down.
What are the reasons why a stock might become more or less desirable? One factor is the underlying economic performance of the company. When a company earns more money, particularly when it earns more than the expectations of Wall Street analysts, buyers rush in to buy the stock. On the contrary, when a stock underperforms economically, shareholders tend to want to sell the stock.
Macroeconomic factors play a role in stock price movements as well. When the economy as a whole is booming, and when the future looks bright, investors tend to buy more stocks in anticipation of future earnings gains.
Sentiment is another factor. Sentiment can be broken down broadly into two categories: bullish and bearish. When investors are bullish, they look on the market favorably. Optimistic buyers with more money in their pockets – such as during economic expansions – tend to buy more stock. If investors are feeling bearish, such as during economic recessions, they tend to sell stocks.
What Moves Bond Prices?
Bonds, as opposed to stocks, tend to hold their value more steadily. Since most bonds come with a promise that a buyer will get his original principal back at some future date, short-term economic hiccups don't register as strongly in bond prices. As long as a company is seen as being solvent and capable of paying back investors' principals in the future, a bond will tend to hold its price more than a stock will.
One factor that does affect bonds much more than stocks is interest rates. When interest rates rise, bond prices fall; when interest rates fall, bond prices rise. While interest rates do have some effect on the stock market, it's much more pronounced with bonds because bonds pay interest.
Imagine you have a bond that pays you 5 percent interest until maturity. If market interest rates go higher – say, to 7 percent – the price of your bond will fall. The reason for this is simple mathematics; after all, who would want to own your bond, paying 5 percent, when they could buy a new bond that pays 7 percent? In this scenario, the price of your bond will fall until the net total expected return of the bond – known as the yield to maturity – is equal.
Stocks, Bonds and Seniority
Another difference between stocks and bonds is their level of seniority in the capital structure of companies. Although stocks represent ownership in a company, they are at the bottom of the totem pole in the case of a corporate liquidation.
Bonds, on the other hand, are senior investments. If a company liquidates, any proceeds that remain are distributed first to the bondholders. Stockholders only receive a payout if something remains after all of the bondholders have been made whole, which is rarely the case when it comes to corporate bankruptcies.
Short-Term vs. Long-Term Investing
Although they generally operate in different ways, there are some similarities between stocks and bonds. Both stocks and bonds are generally considered long-term investments, but plenty of people make short-term profits in both types of investments.
Stock traders buy and sell stocks many times a year – sometimes even many times a day – in an attempt to capture quick, short-term profits. Bond traders rarely move this fast, but any bond investor can choose to sell her bond at any time – such as after a quick dive in interest rates, which will drive the price of a bond up.
Growth and Income Investments
Although stocks are generally considered growth investments and bonds are considered income investments, the opposites can also be true.
High-yield bonds, also known as junk bonds, can trade more like stocks than bonds, with their prices rising or falling based on the economic performance of the underlying company. Some stocks are considered income stocks, as they pay high dividends and don't go up and down in value as dramatically as high-growth stocks. Convertible bonds, which can be converted after a certain date from a bond into a stock at a specific price, are hybrid vehicles that can be considered both growth and income investments.
Choosing Between Stocks and Bonds
The bottom line is that you can make – or lose – money by investing in either stocks or bonds. In many cases, it makes sense to diversify a portfolio by owning both stocks and bonds.