Stocks vs Bonds
Many people beginning to invest ask the question, should I invest in stocks or bonds? The answer to this generic question is almost always, yes. That meaning investing your money is precisely what you should be doing to make it work for you and grow. However, to truly answer whether investing in either is better than the other it is important to understand the differences between the two.
A bond is considered a debt instrument issued by Governments and corporations. You purchase a bond for a fixed amount of money and the issuer agrees to pay you the price of the bond and the interest rate stated at the time of purchase. For example if you purchase a bond yielding 5 percent interest and bought it for a thousand dollars, for the term of 1 year you would end up with 1050 dollars upon maturity the following year. Essentially what you are doing is lending the corporation or Government money so they can continue operations or expand, for this loan the issuer pays you interest or ‘the coupon’. Bonds aren’t that simple though, Canada Savings Bonds are fully guaranteed by the Government and so have virtually zero risk corporate bonds on the other hand, are issued by publicly traded corporations and are not necessarily done so by stable companies. That being said corporate bonds are rated from AAA to D or worse, AAA being the best and D or lower being the worst. AAA bonds are instruments issued, generally, by large stable corporations and yield far lower rates than the more risky bonds issued by smaller corporations. Risky bonds normally receive a poor rating and are more speculative investments; in other words you might not see the money you invest ever again, but who knows for certain?
Stocks are pieces of a company. It’s that simple, but the variables affecting the price and the return on your investment are exponentially greater when dealing with stocks. Additionally different corporations can issue different types of stock, the most generic being common and preferred shares. Moreover common shares can be further split into different classes and provide different voting privileges to the owners of the respective shares. The important information about voting rights and bankruptcy implications are fully disclosed to anyone who wants to research or purchase shares in a publicly traded company.
It’s natural to wonder about what affects the price of a stock and there is no simple answer. Many investors strongly believe that the stock market outperforms the fixed income market in the long term, and although this is true as a long term average there is no way to be one hundred percent sure whether or not you are going to pick a winning stock; there are just too many variables to compute to be absolutely certain. Additionally the stock market is frequently influenced by bullish and bearish emotions that do not necessisarly reflect the true value of stocks. To understand the true method of financial analysis to value a company’s stock there are a series of tutorials on stocktrades.ca but they are beyond the scope of this article.
At this point it is necessary to evaluate your own tolerance for risk. One of the first questions a financial advisor will, or should, ask you is about your willingness to ride out a market dip. A question asked by your advisor might be, would you rather be 95 percent certain to make a 5 percent gain or 5 percent certain to make a 95 percent gain? These questions are designed to measure your investing psychology, of course the questions are usually a little more refined than this, and help the advisor to create the basic framework of your portfolio. Based upon your answers your advisor will recommend a split in your portfolio between fixed income investments and stocks. Often I have seen the 35-65 split example used to describe how investments should be allocated. That example maintains that at 35 years of age a person should be invested in 65 percent stock and 35 percent fixed income investments, and at 65 years old a person should be invested in 35 percent stock and 65 percent fixed income investments. The reasoning behind this is quite obvious, and is to decrease the risk and volatility in your portfolio as you get older.
In conclusion there are a vast array of investments in both the categories of stocks and bonds. You can purchase index funds in your stock portfolio and many people believe that this in itself mitigates management costs and market volatility. Conversely there are bonds available that have the potential to yield considerable gains, greater than even many stocks. In closing the investment industry is one in which the investor must research thoroughly before making decisions and that follows the old saying, caveat emptor ‘buyer beware’.