Stocks are shares in a company that can be bought by the investor, effectively giving that investor both an ownership in the company and earnings based on the success of the company. Bonds, on the other hand, act as a loan toward a company or similar entity in which the company agrees to pay the investor back at a certain time with additional, predetermined interest. Different kinds of stocks and bonds that investors can purchase, and their risk, depend largely on what type of investment they are. In general, most bonds are safer than stocks.
The earnings of stocks are tied directly to the performance of the company. Several kinds of stock can be issued by a company, but their market price is always dependent on how successful the company is--or appears to be. This means the stock of a well-to-do company is priced highly and can often be sold for a profit as the price continues to increase throughout the life of the company. The same laws affect stock earnings, which are issued based on the success of the business term by term.
Blue Chips and Small Caps
Because the risk of stocks depends so much on the companies that issue them, stocks are usually divided into several different categories based on risk and reward. Blue chip stocks are the safest, being shares in respected, stable, industry-leading companies that have a long history of successful business operations. As a result, these stocks are valued highly by the market and rarely experience intense fluctuations in price or earnings. Small-cap stocks are at the other end of the spectrum, coming from small, starter companies that have the potential for rapid growth and immense increase in price and earnings, as well as the possibility of business failure or swift stock changes.
Bonds are a contractual loan with an entity, requiring payment of the bond amount back at a certain time along with interest due. The interest rate and term of the bond are set when the bond is created. Bonds can be either long-term, spanning years or decades, or short-term, lasting only a few months or sometimes only a few days. Bondholders can expect to receive the money due to them despite market fluctuations, although changes in the market will affect the likelihood that the bond will be paid back in full, especially if the company is struggling to keep functioning. If a company folds, bondholders are paid before stockholders.
Bonds also work as a market currency, and are continually bought and sold based on their perceived value and interest rates. In this way, they work in a similar manner to stocks, although the factors affecting their value are slightly different.
Safe Bonds vs. Risky Bonds
Like stocks, bonds issued by solvent, successful companies are more dependable and more highly valued than bonds by new or uncertain companies. The most reliable bonds are government bonds, those issued by the U.S. government, which are guaranteed to be paid back unless the government falls. Corporate bonds involve the greater risk that the corporation will not be able to make its payment when the bond matures, which is why corporate bonds have higher interest rates, allowing bondholders to earn more money.
The risk and safety of stocks and bonds depends on which companies either are associated with, including the government. Because bonds are issued with the understanding that investors will receive payment at the end of the term and will receive funds first in case of a company's failure, bonds are considered safer than stocks. However, blue chip stocks can be safer than risky bonds depending on market fluctuations and the success of the company.