Here’s a brief example that describes the difference between stocks and bonds:
Let’s say that Kathy discovers a tremendous unmet need and starts a business in order to fill that need. It’ll be a short while before she starts making money, but from day one she’ll have expenses, so she’ll need money to pay for them up front.
Now, there are two ways that Kathy can get this money. The first way is to sell an ownership interest in her business to you. And the second way is to borrow money from you.
So, when she sells an ownership interest, what she’s doing is issuing shares of stock. And when she borrows the money, she’s issuing a bond.
What is a Stock?
In other words, stocks represent an ownership interest in a company. When a company issues stock, it’s selling a part of its business to the person who purchases shares of the stock. Then, the company receives the money from the stock issue and uses it to fund its business operations.
Now, as an investor who owns these shares of stock, you expect to profit in two ways: by receiving dividends that the company pays out of its profits on a regular basis, and by the increase in the value of your stock shares as the company prospers.
What is a Bond?
On the other hand, when you invest in bonds, you’re lending a specific amount of money to the bond issuer. Now, bonds are issued by a number of entities, including corporations and various government agencies. And in return for lending your money, the issuer promises to provide you with a return on your investment in the form of interest payments on a regular basis, as well as a return of the face value, or principal amount of the bond.
Now, nothing keeps a company from issuing both stocks and bonds. And in fact, that’s what many big companies do.
But, if it does both sell shares and borrow money, then by law it needs to pay the lenders’ principal and interest first. Only after they’ve been paid, and only after its other ongoing business expenses have been paid, can it then pay out any remaining profits to owners of shares in the company.
Why Stocks are More Profitable than Bonds
In other words, as an owner of stock in a company, you’re actually a residual owner of the business. You see, if, and only if, the company pays off its lenders and expenses will you receive dividend payments.
That’s why, as an investor, having an ownership stake (buying stocks) is riskier than providing a loan to the business (buying bonds), and so the stock deserves a higher expected return than a bond. In fact, this is the reason why, over the course of history, stocks have made more money than bonds.