There are numerous choices available today for those looking to invest their capital as a means of income. Today we will talk about the two most traded investment vehicles … the stock market and the bond market.
It’s important for any investor to understand the differences between stocks and bonds when planning their investment plan and strategies, depending on their overall income goals.
Stocks, also called equities, are traded in shares on a publicly owned company. Buying stocks, or a derivative of a stock such as options or futures, represents purchasing a small stake in the company. Stocks are traded on stock exchanges.
The main stock exhanges in the USA include:
- New York Stock Exchange (NYSE). The NYSE is the world’s largest exchange, based on the market cap of securities listed. Many of the largest public traded companies are listed on the NYSE. The inception of the NYSE took place on May 17, 1792. In an effort to organize securities trading in New York City, the Buttonwood Agreement was signed by 24 stock brokers at the location of 68 Wall Street … and trading began on the New York stock Exchange. Folklore has it that the signing of this historic agreement took place under a buttonwood tree.
- Nasdaq. The Nasdaq is an electronic, worldwide exchange listing securities of smaller companies from around the world. Financial and technical stock make up the bulk of this exchange. However, the Nasdaq also includes utilities, consumer products, and those companies in the healthcare industry.
- American Stock Exchange (AMEX). The American Stock Exchange, also known as the NYSE American Exchange, was initially known for introducing new asset classes and products. Also an electronic exchange, the AMEX was the first to introduce ETF’s (Exchange Traded Funds) in 1993.
There are many other stock exchanges worldwide. A list of the major exchanges by size can be found here: https://en.wikipedia.org/wiki/List_of_stock_exchanges
The main function of the stock market is to provide a regulated environment where buyers and sellers come together for the execution of their trades. These regulations insure traders that all transactions are done openly, with pricing that is honest and fair. This controlled environment also helps the companies whose securities are listed on that particular exchange.
What are the components of the stock market?
- The primary market is held for the initial public offerings (IPOs) by first-run equities. Underwriters facilitate this primary market, and set the initial prices for the securities being offered.
- The secondary market then opens up; this is where the most trading activities are placed.
Basically, bonds are a fixed-income loan the investor provides to a corporate or government entity. The bond market is also known as the credit or debt market. When you purchase a bond, or a credit/debt security, you are actually providing a loan for a particular period of time, and charging interest. This is the same way banks provide loans to customers.
Unlike the stock market, the bond market does not have a centralized location to trade. Without this central location, bonds are sold over the counter (OTC).
What are the components of the bond market?
There are three main components in the bond market:
- Issuers. Issuers are entities that are behind the development, registration, and selling of instruments on the bond market. Issuers operate in the same manner whether they are government entities or corporations.
- Underwriters. Underwriters, for the most part, evaluate risks in the financial world. An underwriter in the bond market buys securities from the issuers, and then resells them for a profit.
- Participants. Participants in the bond market are entities who purchase and sell bonds and related securities. By purchasing bonds, the participant is issuing a loan for the length of the security. The participant receives interest in return for the loan, and at maturity the participant collects the face value of the bond.
How are bonds rated?
There are bond rating agencies who give an investment “grade” to bonds. Standard & Poors and Moody’s are examples of two bond rating agencies. Example of bond ratings are “AAA” or “A”, meaning a high quality/lower risk investment. A bond with a rating of “A-“ or “BBB” is considered to have medium risk. Any bond with a rating of “BB” or lower is viewed as a high-risk investment.
What are the differences between the stock market and bond market?
- A major difference between the stock market and the bond market is the risk involved. In the stock market, investors have risks associated with economic events, geopolitical news, interest rates, etc. The overall stock market tends to move up when all is quiet on the “news” front. With bonds, it tends to be the opposite… when interest rates rise, bond prices may move down. Bonds also put the investor at risk with their rating … if you purchase a bond from a company that does not have a stellar bond rating, you are putting yourself at risk.
- Some analysts believe that investing in certain sectors of the bond market are less risky than trading in some sectors of the stock market, which can be prone to higher volatility swings. One example is investing in U.S. Treasury securities, considered to be a low-risk bond investment.
- The size of the bond market compared to the stock market is very similar. Based on total capitalization, the stock market has about $30 trillion market cap, and the total amount of debt owed through bonds is just over $40 trillion market cap.
- Investors looking for a faster return on their capital may look to the stock market for their portfolio. However, while the bond market may not provide that same opportunity for shorter term higher gains, it can have its place balancing investment portfolios with a steady return. Some choose to hold bonds as a way to save for long-term needs.
In summary, both the stock market and the bond market provide many opportunities for investors. Building a portfolio which includes both stocks (or their derivatives) and bonds may be a viable direction for you to consider. As always with any form of investing, be sure you have a complete understanding of the risk:reward before investing live capital.