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The Difference Between Stocks, Bonds, and Mutual Funds
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Posted By Kam McKee
When investing, it is often suggested that you try the securities market. But when you enter the market, stocks, bonds, ETFs, futures, options, commodities, currencies, and numerous other options create a cloud of confusion.
Where to invest? Which one to choose? One simple way to decide is to understand the different options. In this article, let’s clear the fog for stocks, bonds, and mutual funds.
What is a stock?
Stock is a representation of a company’s ownership. Owning stocks, equity, or shares makes you a shareholder, meaning you own part of that company. For instance, if a company has 10,00,000 shares and buys 10,000 of them, you own 1% of the company.
When a company wants to raise funds for growth, new products, or debt repayment, it issues its stocks in the market. When the company is not listed on the share market and is introducing its shares, it is done through IPO (Initial Public Offering). After listing, the company stocks are traded on the stock exchanges, where prices fluctuate based on supply and demand.
Stock earnings come in two primary ways: selling shares at a price higher than what you paid (capital appreciation) or through dividends (regular payments made to the company’s shareholders from its earnings). Another riskier way to profit from stocks is through derivatives, instruments whose value is tied to underlying assets like stocks and bonds.
Stocks come in two types: common and preferred. The key difference is that common stockholders have voting rights in corporate decisions, while preferred stockholders don’t. However, preferred shareholders get priority in receiving dividends before any are paid to others. There’s also ‘convertible preferred stock,’ which is a preferred stock with the option to convert into a fixed number of common shares, usually after a set date.
What are bonds?
Bonds are an investment that helps governments and corporations raise money, similar to a loan. Instead of owning stock or receiving dividends, you earn interest on the bonds you purchase. For instance, if a company needs Rs.20 crore for a project, it might issue a 3-year bond to raise the funds. When you buy this bond, the company pays you regular interest. At the end of three years, the principal is repaid as per the face value of the bond, along with any remaining interest payment.
There are two main types of bonds: government and corporate. Governments issue bonds when they need funds, while businesses prefer bonds over loans because they typically offer lower interest rates and better terms. The other types of bonds include zero-coupon bonds and municipal bonds.
Though bonds are less volatile than stocks, they still carry risks. You might lose money if the bond’s market value drops due to rising interest rates or a decrease in the bond’s credit quality before maturity. Bonds are known as fixed-income instruments because they provide a predetermined return in the form of interest. Credit rating agencies like CRISIL, ICRA, and CARE rate bonds to inform investors of the associated risks.
Though stocks and bonds differ, one instrument can combine the two in one basket: mutual funds.
What are Mutual Funds?
Stocks and bonds are two different types of asset classes. In contrast, mutual funds are pooled investment vehicles. A group of people pool funds and invest in a few securities. When you invest in a mutual fund, your money joins that of other investors to buy various securities. This gives you instant diversification as the basket of investments may contain stocks from different sectors or a combination of stocks and bonds.
Mutual funds are different from stocks. You don’t own shares of the stocks the fund invests in; instead, you own a piece of the fund itself. Typically, mutual funds are managed by fund managers at financial corporations. Once you buy into a fund, you cannot control which assets are bought or sold. This means you’re investing in a mix of various assets rather than in a specific stock or bond. Additionally, there’s usually a fee or commission associated with mutual funds, which is something to keep in mind.
How do Stocks, Bonds, and Mutual Funds Differ from each other?
| Aspect | Mutual Funds | Stocks | Bonds |
| Ownership | A portion of the fund | Shares of a specific company | Debt issued by a company or government |
| Diversification | Instant diversification across multiple assets | Depends on how many different stocks you buy | Depends on how many different bonds you hold |
| Management | Professionally managed by fund managers | Managed by the investor | Managed by the investor |
| Control | No control over specific investments | Complete control over buying and selling stocks | Full control over buying and selling bonds |
| Risk Level | Generally lower due to diversification, depending on the securities in the fund | Higher. It varies with each stock | Lower, but varies with the issuer’s creditworthiness |
| Return Potential | Moderate, depending on the fund’s performance | Potentially high, but with higher risk | Fixed returns, generally lower than stocks |
| Fees/ Commissions | Typically involves management fees or commissions | Brokerage fees for buying/selling | Brokerage fees for buying/selling |
| Liquidity | High, but may include exit loads | High, can be sold anytime during market hours | High, but selling before maturity may result in a loss |
| Investment Horizon | Suitable for medium to long-term goals | Ideal for various terms, from short to long | Typically suitable for medium to long-term goals |
Conclusion:
Understanding the stock market basics is crucial before you start investing. Stocks, mutual funds, and bonds offer unique growth opportunities but differ in risk, return potential, and management style. So, whether you’re looking to understand what is stock market is or just exploring your investment options, knowing the differences between these basic market instruments can help you make informed decisions that are tailored to your financial goals.
FAQs:
- What are the types of mutual funds?
Mutual funds can be of many types based on the securities they invest in, including (but not limited to) large-cap funds, small-cap funds, multi-cap funds, mid-cap funds, dividend yield funds, ELSS mutual funds, liquid mutual funds, balanced hybrid funds, arbitrage funds, and many more.
- How are the stock market and bond market different?
In the stock market, you trade ownership shares in companies. Meanwhile, in the bond market, you trade debt securities, lending money to entities in return for interest payments.
