Choosing what type of investments to include in a stock portfolio can be challenging for the average investor. For the most part, the decision to add bonds, equity or both to your investment portfolio should be based on your investment goals. Understanding the differences between bonds and equity, or stocks, can help you make better investment decisions on which options will improve your financial picture.
Advantages of Bond Investments
Including bonds in an investment portfolio provides the investor periodic interest revenue for the length of the bond. The interest revenue is based on the bond’s interest rate and principal amount invested. For the duration of the bond, the bond’s interest rate does not change, so you know the amount of revenue you can expect. If a bond issuer defaults on the bond’s payment terms, you have a greater chance of recovering interest and principal payments, because bond investors are creditors with the first claim on company assets.
Disadvantages of Bond Investments
Bonds are subject to interest rate risk. Since a bond’s interest rate does not change, market changes in interest rates can lead you to earn a lower investment return. In a rising interest-rate environment, if you want to sell a bond with an interest rate that is lower than the current market rate, you will have to sell the bond at a discount, or a reduced price than what you originally paid for the bond. Selling a bond at a discount negatively affects your investment portfolio’s return.
Bonds are also subject to default, which can jeopardize your principal and interest revenue.
Advantages of Equity Investments
Stock or equity investments provide an investor with the highest possible returns. When investing in stock, you become an owner of a percentage of the company based on the number of shares you purchase, unlike a bond investor, who is a creditor. As an owner, you can profit from increases in the share price, which result in capital gains, and you can also earn dividend income if the company declares dividends.
Depending on the amount of shares you purchase, equity investments can also allow you to vote on business issues affecting the company.
Disadvantages of Equity Investments
Stocks are riskier and more volatile than bonds. They can provide an investor with higher returns than bonds, and they're also subject to greater losses. If the company goes out of business, an equity investor has last claim on assets, so you have a greater chance of losing your investment. A decreasing stock price can also subject an equity investor to capital losses.
A company may not be required to make dividend payments the way it must make a bond’s interest payments. A company chooses when it pays dividends; this decision is based on current business and market conditions.