In the investment world, you will often hear about stocks and bonds. Here are two possible forms of investment. They allow you to invest your money in a particular business or company with the possibility of future profits. But how exactly do they work? And what is the difference between the two?
Bonds:
Let’s start with bonds. The easiest way to define a bond is through the concept of a loan. When you invest in bonds, you are essentially loaning your money to a company, corporation, or government of your choosing. That institution, in turn, will give you a receipt for your loan, along with a promise of interest, in the form of a bond.
Bonds are bought and sold on the open market. Their fluctuations in value occur in proportion to the interest of the general economy. Basically, the interest rate directly affects the worth of your investment. For instance, if you have a thousand dollar bond which pays the interest of 5% yearly, you can sell it at a higher face value provided the general interest rate is below 5%. And if the rate of interest rises above 5%, the bond, though it can still be sold, is usually sold at less than its face value.
The logic behind this system is that the investors deal with a higher rate of interest then the actual bond pays. Thus, the bond is sold at lower value in order to offset the gap. The OTC market, which is composed of banks and security firms, is the favorite trading place for bonds, because corporate bonds can be listed on the stock exchange, and can be purchased through stockbrokers.
With bonds, unlike stocks, you, as the investor, will not directly benefit from the success of the company or the amount of its profits. Instead, you will receive a fixed rate of return on your bond. Basically, this means that whether the company is wildly successful OR has an abysmal year of business, it will not affect your investment. Your bond return rate will be the same. Your return rate is the percentage of the original offer of the bond. This percentage is called the coupon rate.
It is also important to remember that bonds have maturity dates. Once a bond hits its maturity date, the principal amount paid for that bond is returned to the investor. Different bonds are issued with different maturity dates. Some bonds may have maturities of up to 30 years.
When trading bonds, the biggest investment risk you face is the possibility that the original investment amount is NOT returned to you. Obviously, this risk can be controlled somewhat through a careful assessment of the companies or institutions in which you choose to invest.
Companies with higher credit ratings are generally safer investments when it comes to bonds. The best example of a "safe" bond is a government bond. Another type is investment-grade corporate bonds. Blue chip companies are established companies with a long history of success. Of course, these companies will have lower coupon rates.
If you're willing to take on more risk to get better coupon rates, you'll probably choose companies with poor credit ratings, unproven or unstable companies. Keep in mind, there is a great risk of default on the bonds from smaller corporations; however, the other side of the coin is that bondholders of such companies are preferential creditors. They get compensated before the stockholders in the event of a business going bankrupt.
So, for less risk, choose to invest in bonds from established companies. You will be likely to cash in on your returns, but they will probably not be very large. Or, you can choose to invest in smaller, unproven companies. The risk is bigger, but if it pays off, your bankroll will also be bigger. As in any investment business, there is a trade-off between the possible risk and reward of a bond.
Stocks:
Stocks represent shares of a company. These shares give partial ownership of the company to you, the shareholder. Your shares in this company are determined by the number of shares that you, the investor, own. Stock comes in midcaps, small caps, and large caps.
As with bonds, you can decrease the risk of stock trading by choosing your stocks carefully, assessing your investments and weighing the risk of different companies. Obviously, an entrenched and well known corporation is much more likely to be stable than a new and unproven one. And the stock will reflect the stability of the companies.
Stocks, unlike bonds, fluctuate in value and are traded in the stock market. Their value is directly based on the company's performance. If the company is doing well, growing and making a profit, so is the stock value. If a company weakens or fails, its stock will decrease in value.
There are different ways to trade stocks. In addition to being traded like shares of a company, shares can also be traded in the form of options, which are a type of futures trading. Shares can also be sold and floated on the stock exchange on a daily basis. The value of a certain stock can fluctuate depending on the ups and downs of the stock market. For this reason, investing in stocks is much riskier than investing in bonds.
Stocks and bonds can be profitable investments. But it's important to remember that both options also carry some risks. Being aware of this risk and taking steps to minimize and control it, rather than vice versa, will help you make the right choices when making your financial decisions. The key to sound investing is always good research, a solid strategy, and advice you can trust.
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