Investors have a wide array of asset classes to choose from while deciding on portfolio allocation. The most widely held asset classes are stocks and bonds. As per one school of thought, the portfolio diversification is dependent on the allocation of investable funds between these two asset classes in the individual’s portfolio.
It then becomes imperative that the difference between stocks and bonds are known to the investor on a fundamental level to make an intelligent asset allocation decision.
Stocks and bonds are issued by the corporate bodies to primarily raise funds for meeting the organisations’ capital requirements, which could be for the expansion of the organisation or to meet the organisations day’ to day operating fund needs. So, from an entity perspective, stocks and bonds are means to achieve its fund requirements.
However, the two are fundamentally dissimilar. Companies basically issue stocks to the investors, wherein the investor gets part ownership of the entity post the purchase of the stocks. Hence the stocks are also commonly referred to as shares. The entity is under no obligation to return the money raised via the issuance of stocks.
Bonds, on the other hand, are debt instruments used by the entities to raise funds. The investor in bonds is basically lending money to the entity for a promised rate of interest (coupons). The entity is under the legal obligation to return the money raised from the investors via the bond issuance.
With the purchase of shares, the investor technically becomes the part owner of the company. The company while issuing the shares does not guarantee any returns to the investor, however, the company could choose to pass on the profits generated to its investors in the form of dividends. It must be noted that the issue of dividend is completely at the discretionary of the company and it could decide to forgo the issue of dividends if it chooses to invest the amount for further projects or retain them as reserves.
On the other hand, when an entity issues bonds, it is legally obligated to pay back the investor the principal amount on its maturity date and the bond coupons as mentioned on the bond certificate. The entity cannot decide to pay its coupon based on its financial position, and if it does not pay the promised investor its coupon, the entity is said to have defaulted on its debt. The bondholder could take legal action on the entity under such conditions.
The value of stocks is primarily dependent upon the economic performance of the company. Also, factors like overall market sentiment and the macroeconomic conditions also impact the stock price. The investor makes money in stocks when the price of the shares moves up in value and, as and when the company pays dividend, i.e. if it chooses to do so. The investor’s major incentive to make money is usually via the appreciation of the share price. However, some investors make an investment in stocks for the dividend income as well.
The bond investor is somewhat immaterial to the economic performance of the company since the interest payment (coupon payment) is predetermined and the company is legally obliged to the bondholder. Even if the company performs enormously well, the bondholder does not get any extra incentive from the company. Hence, the returns are limited and predetermined.
The stockholder comes last in the claim to the entity in case of a bankruptcy of the entity. The bondholder, on the other hand, comes at the top of the claim hierarchy in case of a bankruptcy.
The return on investment in stocks due to the above-discussed reasons is extremely volatile, and the risk is comparatively high as there is no technical legal cover to guarantee the returns. At the same time, the returns from a stock investment are also very lucrative if the concerned company improves its performance.
On the other hand, the return on investment from bonds is predictable and hence are less volatile and relatively safe. The bondholder does not get to make more money than the promised coupon rate, and therefore the returns are limited.
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