Sunday, January 20, 2019

Difference between stocks and bonds

A little while back, I had the opportunity to help a student on some work for a personal finance class. I attempted to explain to this student the main differences between owning a share of stock in a company, and owning a bond. And here's the general gist of it, explained briefly in my own words, in case you ever come across this in class, too. Please note that I am not a financial advisor or expert of any kind on these subjects. 

When you own stock in a company, you own a piece of that company. You're an actual owner of the business. Now, in very large, publicly-traded companies that have a national or even a global presence, there may be millions of other stockholders (also known as shareholders) of the company, but you're still an owner.

As a shareholder, the company may reward you from time to time in the form of a dividend. The company isn't obligated to make these payments to stockholders, and if it is currently making such payments, it can decide to lower, raise, delay, or eliminate them at any time. Dividends to shareholders are usually, though not always, tied to the financial performance of the business. If the company is performing poorly, chances are likely it's not going to be paying dividends. In times of poor financial performance, the value, or price, per share of the actual stock itself may fall, as well, so you may lose money on your investment that way, too.

On the other hand, when you own a company's bond (keep in mind that bonds can be issued by governments, as well), you do not own a piece of the company. You're not a shareholder. Rather, you are giving a loan to the business (or government entity). In exchange for the loan, the company is agreeing to not only pay back the amount of money you loaned to it - the principal - but it is also agreeing to pay you interest, as well.

The advantage to owning bonds is that they may typically be more financially stable compared to stocks - you're getting consistently stable interest payments from your loan to the company. As a lender to the company, you also usually have more rights in bankruptcy court than stockholders do, if the company runs into that situation. You're more likely to be compensated in a bankruptcy proceeding before shareholders.

A downside to owning bonds over stocks is that, even though stocks are usually far more prone to volatility, the possible financial rewards when stocks are performing well can potentially be far greater than bonds can ever hope to achieve.

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