Companies need money from investors to grow, and they raise this capital by issuing stock and bonds. Total U.S. equity and bond holdings at the end of 2010, including foreign and government bonds, were over $40 trillion, according to the U.S. Census Bureau. As a stockholder, you own a piece of the company and participate in its success. As a bondholder, you lend the company money and expect it to pay you back, with interest, as specified in the term of the bond. Several factors determine which investment is the most beneficial for you.
Shareholders receive income from selling their stocks at a profit, and from dividends, if the stocks pays any. The risk for owners of stock comes from the uncertainty regarding future stock prices and from the possible failure of the business. If the stock goes down, you can lose money. If the company goes bankrupt, bond holders are paid first and stockholders may get nothing.
Bond holders get their income from the interest that the bond pays. This interest income is set at the time the company issues the bond and the bond holder can expect to receive the interest until the bond's maturity. This reduces risk but rising inflation may erode the fixed bond income. Bond holders may sell their bonds before maturity, but the price varies inversely with the prevailing market interest rates.
The rate of return before fees and taxes depends on how much profit the investment generates and the amount of the investment. Divide the income for the year by the cost and multiply by 100 to get the rate of return. For bonds, you can calculate the rate of return at the time of purchase because it depends only on the purchase price and the interest rate. For stocks, you can determine the rate of return after selling the stock, when you know how much money you made.
If you bought stock for $1,000 and sold it a year later for $1,050 after receiving $20 in dividends, you made a $70 profit on the stock that year. Since your initial investment was $1,000, 70/1000 = .07. Multiplying by 100 gives you a 7 percent rate of return.
Transaction fees can eat into your investment income and reduce it far below what you were expecting. Buying a bond and holding it to maturity has few easy-to-calculate fees. You only pay a commission on the initial purchase and you may have to pay an annual maintenance fee for your investment account. Buying and selling stocks frequently or buying mutual funds that have elevated fees reduces your rate of return by several percentage points. As a stockholder, you have to make sure that the profit you expect from your trades covers your transaction fees as well as your expected rate of return.
The tax treatment for interest, dividends and capital gains is different. The tax rates often change and are different from the rates for ordinary income. How you calculate your investment income and what you can deduct also influences your taxes. Depending on your personal financial situation and the jurisdiction in which you pay taxes, which type of investment benefits you most will vary.
If you live in a state with high income taxes, buying federal bonds not subject to state taxes may be a good investment. If you have a low income and a low tax rate, interest taxed at the rate of ordinary income may be attractive. Consulting a financial adviser or estimating your income from different types of investments and calculating the effect on your taxes helps you make a decision.
- Florida International University: Stock and Bond Basics
- University of Oregon: Capital Structure - Debt vs Equity
- Wake Forest University: Relationship Between Stockholders and Bondholders
- U.S. Census Bureau: Equities, Corporate Bonds, and Treasury Securities— Holdings and Net Purchases by Type of Investor - 2000 to 2010
- Dynamic Graphics Group/Dynamic Graphics Group/Getty Images