What is the difference between stocks and bonds?
Before we review five areas of how stocks and bonds are different, let’s define what
is a stock and let’s define what is a bond.
A stock is a type of investment that represents the ownership of a fraction of a corporation.
As in: here’s the part that I own of the company in red, versus the part that all other
shareholders own in blue.
Don’t see any red in the picture?
Look very closely, it is a tiny tiny little slice.
Bonds are different.
A bond is a loan from an investor to a borrower such as a company or government.
So what can you expect when investing in stocks, versus investing in bonds.
Let me tell you the story of five key areas where the investment experience can be wildly
different.
Bonds on the left, stocks on the right.
First area: the payoff.
How much money can I make when investing.
For bonds, that tends to be predictable with limited downside.
The related emotion to that payoff is that investing in bonds is in most cases pleasantly
boring.
Here’s an example of a bond I invested in.
Prior to investing, I received this schedule with 16 important dates.
Every three months, the bond promises to pay an interest of €15 per quarter, which is
€60 per year, every year, on a principal amount of €1000, in other words 6% interest.
That’s why bonds are sometimes called fixed income investments.
A pleasantly boring bond.
Hopefully.
Why 6% interest?
Isn’t that very high?
Yes, it is.
The company that issued the bond is a start-up, with exciting plans but little track record.
So the big question is: will all the interest payments, and the repayment of the full principal,
happen.
It's important to note that in this particular case, the full principal amount is expected
to be paid back at the very end of the loan period, this is called a “bullet” payment:
the entire principal value is paid in one lump sum on its maturity date, rather than
amortized over its lifetime.
What if the bond is publicly traded and I want to sell it before the end of the term?
For a publicly traded bond, the bond price in the market can fluctuate if interest rates
go up or down.
If the interest rate in the market goes up, then this bond I own will become less attractive,
and the bond price could drop.
If the interest rate in the market goes down, then this bond I own will become more attractive,
and the bond price could go up as other investors are willing to pay more for it.
How about the payoff and related emotions of stocks compared to bonds?
For stocks, anything goes in terms of payoff: way down, down, flat, up, or way up, and hence
your emotions when investing in stocks could be anywhere between despair, boredom and euphoria.
Here’s a picture for despair: buying a stock at $200 per share, and having it drop by two
thirds over a year, with no immediate signs of recovery.
If only I hadn’t invested in that one.
Here’s a picture of how stocks can be relatively boring as well: buying a stock five years
ago for $50, seeing it fluctuate between $45 and $60, and then dropping pretty much to
where you started out: $51.
In addition, the stock has a 5% dividend yield, as the company pays a quarterly dividend of
64 cents, or $2.56 per year, on a share price just over $50.
That almost remotely looks like a bond!
Almost, as historical share price patterns and historical dividends provide no guarantee
for future performance.
And here’s the picture for euphoria: having a stock go from $450 to nearly $700 within
a few months.
Excellent returns.
If only I had bought and sold more of those at the right time!
Euphoria can turn into boredom or despair, when in the next few months the stock finds
its way back down to $450.
And no, the stock does not pay any dividend either.
What skills do you need to invest in bonds?
The main one is to read small print: carefully studying the offer document which includes
terms and conditions, effective returns versus nominal returns, security and collateral,
risk factors, etcetera.
Basically, as a bondholder you end up on the right-hand side of the balance sheet of the
company in non-current liabilities.
What you need to verify is what assets will be bought or financed on the left-hand side
of the balance sheet with the capital you provided.
Are these assets that will generate sufficient returns?
Are these assets that have a solid market value in case they need to be liquidated?
What skills do you need to invest in stocks?
On the one hand, the ability to visualize and dream.
On the other hand, the ability to spot psychopaths.
Visualizing and dreaming: can you read, understand and buy into the investor presentations that
speak of the company’s vision, mission, strategy, technology, and its prospects for
revenue growth and margin improvement?
Spotting psychopaths: can you recognize and stay away from companies whose CEO either
displays reckless behavior, or is clearly out of touch with reality?
What if things don’t go well after you invested.
What is the possible damage if the company you invested in goes bankrupt?
In the case of investing in bonds, you will probably be able to achieve a partial recovery
of the amount you invested.
In the case of investing in stocks, you will probably lose all that you have invested.
Why is that?
In a bankruptcy, anybody that the company owes money to is asked to queue in order of
seniority.
In the front of the queue are the tax authorities, suppliers, employees, and lenders that provided
senior debt.
In the middle of the queue are lenders that provided subordinated debt (which is debt
that is “lower in rank”).
All the way in the back of the queue are the shareholders.
In a settlement, those in the front of the queue probably recover bigger or smaller amounts
depending on their legal rights and preferential status.
There might be a bit of a haircut, but hopefully not a full write-off.
If you are in the middle of the queue, you might recover something, but not as much as
the senior creditors.
If you are at the back of the queue, chances of recovering anything are slim.
That’s why bonds are considered less risky that stocks.
When you read the small print before investing in a bond, make sure you check whether the
bond is “senior” or “subordinated”.
Can investing in bonds or stocks lead to big regrets?
Certainly.
Both can go horribly wrong.
Let me give you some examples.
When investing in bonds, you want to avoid being overconcentrated, in other words: having
too much money in just one bond.
In case of damage to the company, it might take a long time before you can get a partial
recovery executed.
Another mistake is to be fully invested but needing liquidity, in other words you may
have optimized your portfolio to generate maximum interest income, but have no cash
buffer for unexpected events.
When investing in stocks, the big regrets can be far more severe.
Two dramatic examples.
Financial leverage (investing with borrowed money) can “multiply” gains, but wipe
you out completely in case of unexpected losses.
Your stock portfolio gets liquidated, and you are left with debt and no assets.
Or if you are reckless enough to short sell a stock, you might get short squeezed if the
stock goes up dramatically and you have to buy it back at much higher prices.
There you have it: the difference between investing in bonds and investing in stocks
in five major areas.
I would love to hear your experience with bonds and stocks in the comments below.