Stocks and bonds are a power couple aka the David and Victoria Beckham of the investment world. They’re often paired together in a diversified investment portfolio to mitigate risks and maximise returns.
Bonds vs stocks overview
Stocks and bonds often complement one another as prime asset classes but generate returns very differently. Stocks have to appreciate in value and be sold at a higher price than purchased to make a profit, while the majority of bonds, including corporate and government bonds, pay investors a fixed interest over time.
Stocks or shares (also known as equity) are securities that give you partial ownership of a company, also known as equity. Purchasing stocks means purchasing small ‘slices’ or shares of a company, and of course − the more shares you buy, the more of that company you own. Investors buy stocks with the aim that they think will go up in value over time to generate returns. The most common reason companies make a public offering (issue shares to the public) is to raise capital to fund future growth.
If the company you invested in performs well and grows in value, your shares will also, and this creates potential for bigger returns. Do keep in mind that the only way to ‘cash in’ returns on stocks is to sell them at a profit. The opposite, however, is also possible where if the company performs poorly, the value of your shares could plummet. In this instance, if you sold them, you’d lose money. In short, stocks provide greater opportunities for higher returns, but also carry greater risks.
4 types of stocks to buy
- Growth stocks: shares you buy from companies expected to grow at an above-average rate relative to the market and which will generate a positive cash flow year on year.
- Dividend stocks: pay dividends or a portion of the company’s profits to investors to create passive income.
- New issues: are shares (or bonds) issued for the first time, also known as Initial Public Offerings or IPOs.
- Value stocks: provide consistent dividends and stable earnings regardless of the state of the overall stock market.
Bonds in a nutshell
Bonds are a loan from you to a company or government, with no equity or shares involved. When you buy bonds, a company or government is in debt to you and will pay you back the full loan amount after the maturity period, all the while receiving interest on the loan − which is your return on investment. Regular interest payments can then be used as a source of fixed passive income over time. The main benefit of bonds, is that you know exactly what you get, although your return potential is capped at the interest rate. In short, bonds carry less risk, but also offer less opportunity for greater returns.
It’s also worth mentioning that although bonds may be considered safer than growth assets like shares or property, they aren’t 100% risk-free. For example, if the company that issued the bond collapsed before maturity, you’d stop receiving interest payments and may not get back your full loan amount. Bond durations and the term to maturity can range from 30 days, up to 30 years.
Bonds are normally assets by a rating company. Most of them have a similar rating system:
- AAA (best possible rating, very safe and low default rate of 0% to 0.5%)
- AA (default rate of 0.02% to 0.54%)
- A (default rate of 0.02% to 0.54%)
- BBB (default rate of 0.5% to 2%)
- BB (default rate of 1.2% to 20%)
- B (default rate of 5% to 45%)
- Junk bonds (default rate of 17% to 70%)
Bonds with AAA to BBB credit ratings are considered investment-grade bonds and regarded as safe. For example, pension funds are only allowed to buy these bonds. Bonds with BB to C credit ratings are non-investment grade bonds and those below are ‘junk’ bonds.
6 types of bonds to buy
- Corporate bonds: are investment-grade debt securities issued by private companies to raise capital to fund growth.
- High-yield bonds: are corporate bonds with lower credit ratings below investment-grade that tend to pay higher interest rates, to compensate investors for taking on the risk.
- Government bonds: also known as sovereign bonds, are issued by a national government to support government spending or finance budget deficits.
- Municipal bonds: are issued by a state or municipality to finance capital expenditures, including the construction of highways, bridges or schools.
- Foreign bonds: are issued by a foreign entity (such as a government or corporation) in a foreign financial market’s currency as a means of raising capital.
Are bonds safer than stocks?
Bonds are often considered safer than stocks for the primary reason that they’re less susceptible to market fluctuations and geopolitical risks. In principle, this makes bonds less volatile and less risky than shares. When held to maturity, bonds can provide more stable and consistent returns than stocks. Plus, interest rates on bonds often tend to be higher than rates of standard savings bank accounts.
What percentage of stocks and bonds should be in your portfolio?
The golden rule for a stocks vs bonds split is based on the principle that the stocks percentage of your portfolio should equal to 100 minus your age. So, if you’re 60 years old, 40% of your portfolio should be equities (100 - 60 = 40%). The rest can be made up of bonds, including high-grade and high-yield bonds, treasury bonds and other relatively low-risk assets. Remember, however, that the asset allocation of any portfolio should be reflective of your investment timeframe, your risk appetite, your overall wealth (including property), your financial goals and your stage of life. It’s best to consult a financial advisor or wealth manager before making any investment decisions.
When to buy bonds?
Bonds are a good investment option for investors nearing retirement age, due to their lower risk. They’re also a good investment choice for conservative investors with a very low-risk profile.
But be aware that you only get the full ‘low risk’ benefit if you buy a bond at issuance and hold it until maturity. Bond prices are always stated as a percentage. You buy a bond normally for face value at 100% and at maturity you get back 100%. Nevertheless, during the maturity of the bond the price can change significantly. If interest rates drop, the price of bonds can rise above 100%, but if interest rates are rising the price is going below 100% and will rise slowly back to 100% until maturity. Meaning that if you sell the bond before maturity at the wrong time you could make a significant loss with bonds.
When to buy stocks?
First and foremost, do your research on stock companies before buying shares. Look for trends in earnings growth, debt-to-equity ratio and financial statements. Besides that, the basic principle of trading stocks is to buy when prices are low, and sell when they're high. Seasoned traders also typically watch the first few hours of when the stock market opens to spot opportunities to make a quick profit. The first hour or two of every trading day can be chaotic depending on any events that would have occurred overnight. Prices tend to be more stable around midday when all the news have been factored into prices.
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