Comparison of stocks and bonds

2023-09-08
Summary:

Stocks represent investors' equity in a company, while bonds are a lending tool that allows investors to receive regular interest upon purchase.

This article will explore two common investment tools: stocks and bonds, to help you have a clearer understanding of company stocks and bonds and their relationships with investors.


Firstly, let's review what stocks are. A stock is a partial ownership certificate sold by a company to investors to raise funds. They represent the proportion of shares held by investors in the company. However, bonds are a lending tool issued by companies in need of funds, and investors can receive regular interest upon purchase. A bond is a contract that proves the borrower's debt. In short, purchasing stocks is equivalent to becoming a shareholder of a company, while purchasing bonds is equivalent to becoming a creditor of the issuer, just like borrowing from a bank.


Now, we know that when a company needs funds, there are two methods to choose from. One is to borrow money, which means debt, and the other is to sell the company's shares, making investors shareholders of the company, which means selling ownership of the company. We can compare it to the balance sheet of Xiaoming Supermarket. On the left is the total assets of the company, and on the bottom right is the ownership of the company, which is the stocks sold by the company. Assuming the company sells 10,000 shares, if you own one share, you will own one tenth of the company, equivalent to a value of 400 yuan per share.


The liability area may indicate that the company has borrowed $6 million from the bank, which may require repayment after ten years, including interest. Issuing bonds is similar to this, except that their borrowing targets are ordinary investors in the market and may be purchased by many people. Suppose the company wants to issue 6,000 bonds, each worth 1000 yuan. Therefore, if I purchase a bond, it is equivalent to lending money to this company. After the bond matures, this thousand yuan will be returned to me, and of course, during the period, the interest promised at the time of issuance will be paid to me. Assuming the interest rate is six percentage points, a total of 1600 yuan can be recovered after ten years. Like stocks, you can also sell bonds to others in the bond market before they mature.


So, if I hold stocks, I will own a portion of the company's shares. When holding equity, the company cannot guarantee that dividends or bonuses will be paid. If the company decides to distribute dividends or bonuses, both I and other shareholders will receive corresponding returns. However, if the company goes bankrupt, all shareholders will suffer losses. It is worth mentioning that if the company goes bankrupt and cannot continue operating, they will first repay the debt of the bondholders, and if there is still a balance, they will return it to the shareholders who purchased the company's shares.


Now we have a better understanding of the relationship between stocks, bonds, and companies. Next, let's compare their respective strengths and weaknesses, as well as their historical return rates. The advantages of stocks lie in their potential high returns and potential dividends or dividend income. But their drawbacks are high risk and high price fluctuations. If the company goes bankrupt, shareholders will eventually receive compensation. The advantage of bonds is that you know the interest rate before purchasing them and will receive interest on time, making their prices relatively stable. If the stock market plummets, it usually leads to an increase in bond prices, and bond interest rates are generally higher than bank deposit rates. However, the downside of bonds is that if the company goes bankrupt, you may not be able to recover the principal. In addition, if interest rates change significantly, it may lead to losses.


Let's take US stocks and US bonds as an example to compare their historical returns. Although the performance of the United States may not be the most outstanding, its stability is worth mentioning. From 1802 to 2012, the average annual return on US stocks was 8.1%. That is to say, if you invest $1 in 1802, it will grow to $1348,000 by 2012. The average annual return of US bonds is 5.1%, and the US $1 will grow to US $33922. If adjusted for inflation, the average annual return on stocks is about 6.6%, and the average annual return on bonds is about 3.6%. Although these data may seem similar, it should be noted that they have already taken into account inflation factors.


If we look at the data from 1990 to 2012, there have been two major stock market crashes during this period of 20 years. The collapse of the real estate market has led to a sharp drop in interest rates. The global stock market increased by 5.4%, the global bond market increased by 1.8%, and the US stock market increased by 6.2%, while the US bond market increased by 2.0%. These data have also been adjusted for inflation, so there is not much difference compared to the previous two hundred years.

Comparison of stocks and bonds

Stocks Bonds
Definition Partial ownership proof Debt instrument
Ownership Shareholders Bondholders
Interest or Dividends Possible, uncertain Regular interest payments
Risk High risk, price volatility Lower risk, price relatively stable
Returns in case of Company Bankruptcy Compensation received last May not recover principal
Investor Status Shareholders, ownership of company Bondholders, lending to the company
Market Performance High returns, high risk Lower returns, lower risk
Historical Returns High annual average returns but high volatility Lower annual average returns, relatively stable

After reading these comparisons and historical returns, you may think, Why invest in bonds when the return on stocks is much higher than that on bonds? In fact, theoretically speaking, you are right, but please don't forget that everyone's age and risk tolerance are different. Both the technology boom in 2000 and the financial crisis in 2008 led to the serious collapse of the stock market. If people who were about to retire at that time lost most of their pension funds, what should they do in the future? In addition, many investors always buy stocks when the market reaches its peak and then sell them at the lowest point. Even if the stocks slowly rebound in the future, it is difficult to make up for losses. Therefore, when investing, balance is crucial, and you need to make different adjustments based on your age and risk tolerance, which is the healthy financial philosophy.


Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

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