Bonds vs Equity – Which is the Ideal Investment for You
The Main Investment Avenues
The quest for profits is what drives all investments – every investor seeks to deploy his funds profitably and gain high returns on his investment. To this end, investors may choose to invest their funds in one or more of the many different investment avenues (investment classes). Bonds, equity, cash equivalents, real estate, gold (and silver), other commodities, etc. are some of the common investment avenues available to investors.
Among the different investment avenues, bonds, equity, and cash equivalents are considered to be the three main investment avenues (the three traditional investment classes). All other investment avenues are considered alternative investment classes. Typically, the three main investment classes may offer various advantages (to investors) vis-à-vis the alternative investment classes. As a result, many investors prefer investing in the three main investment classes rather than in the alternative investment classes.
Let us quickly understand the different advantages of investing in the three main investment classes vis-à-vis investment in the alternative investment classes. One of the biggest advantages of investing in the main investment classes (especially for small investors) is that, often, investment in these classes may be started with relatively smaller sums of money. For example, investment in real estate may often require a large one-time payment by the investor (as real estate properties may be quite expensive). In contrast, it is generally possible for investors to buy just a small number of cheap shares or cheap bonds in one transaction. Thus, investors may invest in these assets with a relatively smaller amount of funds.
Secondly, the three investment classes may often offer far greater number of investment options than the number of options available in some of the alternative investment classes. For example, the equity market may include stocks of several thousand companies. Equity investors can choose to invest in one or more of these thousands of companies. In contrast, some commodity markets may only include a few hundred (or even fewer) investment options. Other alternative investment classes may similarly offer limited options to investors.
Further, the main investment classes typically offer greater liquidity and transparency to investors vis-à-vis alternative investment classes. Bonds, equity, and some cash equivalents are typically traded on well-organised and regulated markets. As these investment classes are very popular with investors, these markets see a very large number of transactions daily. Thus, generally, investors in these asset classes are able to sell off their assets and recover their money quickly. In contrast, for example, if the owner of a piece of real estate wants to sell the property and recover his money, he may need to wait for several months to get a buyer.
Similarly, the markets that deal with the three main investment classes typically update the prices (on the basis of the different transactions in that market) of various instruments (financial assets) very frequently (generally, many times per second). These markets also display the current prices constantly. Thus, investors can easily (and accurately) find out the prevalent price of any asset traded in these markets. This enables investors to make well-informed investment decisions. In contrast, if we take a look at the real estate market, it may not always be possible to know the exact price at which the last trade in a particular area was finalized. Thus, an investor in real estate may find it difficult to know the exact market value of his holdings. Correspondingly, at times, such an investor may end up selling his piece of property for a price lower than its market value (thereby losing potential profits).
These then are the major advantages that the main investment classes offer to investors (vis-à-vis the alternative investment classes). As a result of these advantages, as discussed above, many investors prefer to invest their money in the three main investment classes rather than in the alternative investment classes. Let us now look at bond investments and equity investments and identify which of the two is more suitable for you.
Understanding Bond and Equity Investments
As we have seen, both bonds and equity are counted among the three main investment classes. However, there are significant differences between these two investment avenues. Let us, therefore, understand these two investment classes thoroughly. We start with bonds.
Bonds are instruments of lending, i.e. purchasing a bond is equivalent to lending money to the issuer of the bond. Thus, the purchaser of a bond essentially becomes a lender to the issuer of the bond (who effectively becomes the borrower). In lieu of the funds borrowed, the borrower (issuer of the bond) pays periodic interest to the lender (purchaser of the bond) – thus, bonds may serve as fixed income instruments. Typically, each bond also has a period of maturity (effectively, the term of the loan). Upon completion of the period of maturity, the borrower returns the original sum (the principal) to the lender. Do note that bonds may be issued by the union government (central or federal government), local government bodies, corporate entities, etc.
Bonds are highly flexible – different bonds may have very different terms and conditions. Thus, bonds offer a lot of variety – and hence, appeal to many different categories of investors. For example, the period of maturity of different bonds may vary widely. The period of maturity of many common bonds may be as short as 2 to 3 years. Other bonds may have much longer periods of maturity – in fact, many common bonds have periods of maturity of up to 30 years. Generally, bonds with longer periods of maturity offer higher rates of return than bonds with shorter periods of maturity.
Bonds are generally seen as relatively secure (safe) investments – for example, bonds are typically considered safer than equity. Government bonds are seen as nearly risk free instruments. Therefore, the rate of return offered by government bonds is often considered risk free return – this return may be used as a benchmark to assess returns offered by other financial instruments.
As bonds are considered safer investments than equity, the rate of return offered by bonds is typically expected to be lower than the rate of return offered by equity. However, some bonds (high yield bonds) may offer very high rate of return. Some bonds (for example, junk bonds) may yield rates of return as high as 50% per year or higher. Such bonds typically carry very high risk of default.
Some bonds may be sold in designated markets before the completion of their period of maturity. Such bonds offer a lot of liquidity to bond investors – these investors can sell such bonds in these markets at any point of time and recover their money. Selling a bond can also provide an additional source of gains (profit). If the purchaser of a bond sells it at a price higher than his purchase price, then he makes a profit on the sale. (Conversely, if the purchaser of a bond sells it at a price lower than his purchase price, then he may make a loss on the sale.) These are some of the salient features of bonds. Let us now understand equity.
As we have seen, a bond is a lending instrument. In contrast, equity is an instrument of ownership. When you purchase the shares of a company, you have essentially purchased a part of the company – you have become a part owner of the company. Equity investments can offer two sources of income. First of all, the price of a share may go up. If an equity investor sells his shares at a price higher than the price at which he purchased them, then he makes a profit.
Secondly, profitable companies often pay dividends to shareholders. A dividend is that part of the profits (or cash reserves) of a company which is paid out to the shareholders. Some companies may issue regular dividends to their shareholders. In such cases, the dividend may serve as a source of regular income (fixed income).
Equity is generally seen as a high-risk, high-return investment. Typically, equity investments are seen as riskier than investments in bonds or investments in cash equivalents. Correspondingly, it is expected that equity would generate higher rates of return than investments in bonds or in cash equivalents. As a result, experts often suggest that most investors should allocate at least some part of their portfolio to equity so that at least that part of their portfolio can be expected to generate higher returns.
Experts also advise that equity investors should have a relatively long investment horizon (at least 5 years long and ideally, 10 years or longer) in order to maximize their chances of getting good returns on their investments. In the short term, market fluctuations may pull down the prices of even good stocks. But over the long term, it is expected that good stocks will perform well and will generate good returns.
Bonds vs Equity – Identifying Your Ideal Investment
Now that you have understood the important features of bonds and equity, you are ready to identify which of these would be the ideal investment for you. In order to do this, you must start by identifying your investment objectives. As we have seen, bonds and equity are different kinds of investments. Accordingly, bond investment and equity investment may appeal to investors with different investment objectives.
Suppose an investor has a relatively shorter investment horizon (let’s say shorter than 5 years). As we have seen, equity investments are ideal for investors with longer investment horizon. On the other hand, different bonds have different periods of maturity. Hence, investors with widely differing investment horizons may be able to find bonds whose period of maturity matches their investment horizon. Thus, investors with shorter investment horizon may invest in short term bonds (with periods of maturity of about 2 to 3 years). This would be especially useful for investors who are somewhat risk averse and want safer investment options (since bonds are relatively secure investments).
Some investors may have a short investment horizon and may be willing to take on more risk. Such investors may target some high growth stocks – for example, shares of companies in rapidly growing industries. Such stocks may be expected to generate decent returns even in the short term, though they would be considered high-risk investments.
Investors with a longer investment horizon may choose to invest in long term bonds if they are relatively risk averse and want safer investment options. On the other hand, if they are willing to take on more risk, they may invest in equity. In this case (i.e. over the long term), it is expected that equity would yield higher returns than bonds.
Another option available to investors is to invest in a balanced portfolio. This ensures that a part of the portfolio is invested in safe, highly liquid cash equivalents, a part is invested in low-risk bonds and a part is invested in high-risk, high-return equity. For investors who have a long investment horizon and who are able to bear some risk, experts often advise investing 10% of the portfolio in cash equivalents, 20% in bonds, and 70% in equity. Similarly, for investors with a shorter investment horizon and lesser risk tolerance, experts often advise investing 40% of the portfolio in cash equivalents, 50% in bonds and 10% in equity. Thus, once you identify your investment objectives, you can design the ideal portfolio that matches your investment objectives.
You have now understood the important features of bond investment and equity investment. You have also understood how to design your own portfolio. Thus, you are now empowered to make smart investment decisions and invest your way to prosperity and success.