Pros & Cons of Stocks & Bonds
There are many reasons to invest in stocks and bonds, from saving for a child's education to putting money aside for retirement. Banks and investment firms also use stocks and bonds to make profits for their shareholders and pay interest to depositors. But stocks and bonds also represent limitations and risks, as all investments do, that investors should be aware of.
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Function
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Stocks are ownership shares in a company. Shareholders profit as the company increases its value and lose money when the company's value declines and there are no buyers willing to pay more for shares of its stock. Bonds are loans to a company or government. Where stock buyers take on ownership, bond buyers agree to specific terms for repayment based on economic factors determined by the bond issuer.
Volatility
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Volatility is the word economists use to discuss the amount of risk that an investment contains. Stocks are traditionally more volatile than bonds, meaning that they can skyrocket in value or plummet suddenly. Bonds, on the other hand, change more slowly and seldom produce the extreme gains or losses that some stocks do. Government-issued bonds are among the least-volatile investments. This means less chance of large gains, but a better chance of slow, steady growth.
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Diversification
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Investors who choose to diversify place money into a variety of investment products. This has the advantage of spreading out the risk. For example, an investor with money in volatile stocks could buy bonds because of the security they offer. At the same time, an investor with a relatively stable portfolio that doesn't include any high-risk investments may be able to afford the risk of buying stocks to open up the possibility of large gains should a particular company or sector of the economy grow very quickly.
Time Frame
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The advantages of stocks and bonds change depending on how long an investor can afford to wait before cashing in, or liquidating, the investment. For example, a young person saving for retirement can take advantage of stocks' large potential for growth, trusting that, over time, any major losses will be erased by later gains. An older investor who needs constant access to cash may prefer bonds, which are more likely to rise steadily.
Alternatives
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Although stocks and bonds are among the most popular types of investments, they are far from the only options. Investors can choose other investments with low volatility like certificates of deposit and savings accounts, which earn a specified amount of interest through a bank and are protected from loss. Mutual funds are pools of stocks that investors can buy into. A professional manager uses the funds in the pool to buy and sell stocks, spreading out the risk over many different companies.
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References
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