The rate of return that is offered on government bonds is even considered a risk-free return. While government bonds are safe investments if compared to equity, the rate of return on bonds is lower than that on equity.
Are you looking to invest your money? Then you must be aware that there are different avenues where you can invest. You must be knowing about some of the common investment avenues available such as bonds, equity, cash equivalents, real estate, gold, and commodities amongst others. But how exactly are you going to invest the money? How much are you going to allocate to a particular asset?
Well, all investments are driven by the quest for profits and higher returns and investors seek ways to deploy their funds profitably and gain higher returns on investment. It is ideal for investors to put their funds in multiple avenues and have a diversified portfolio of investments based on personal goals. However, bonds and equities remain the most traded types of assets.
Both bonds and equities are classified as traditional investment classes while all other types of investments are considered alternative investments. Hence, bonds and equities are the main investment avenues and offer different advantages in comparison to alternative investments.
Advantages of Investing in Bonds and Equities
One of the biggest advantages of investing in bonds and equities is that it allows you to start small. You can start by investing small amounts of money, unlike, let’s say, real estate, where you will need a larger one-time sum for investment. An investor can always start by buying a small number of shares or bonds as the barrier to entry is very low.
Furthermore, there is a far greater number of investment options available when it comes to equities and bonds. For instance, there are several thousand companies offering stocks if you want to invest in equity. It is all the same for bonds with everyone from corporations to the government institutions issuing bonds for the masses.
Also, these main investment classes are fairly transparent and offer far greater liquidity. They are typically traded in well-organized and regulated markets. You remain updated on the prices of various financial assets as current prices are displayed by the markets constantly. This allows an investor to make a well-informed decision.
Now, we know about the advantages of investing in traditional investment avenues but how are they different and what more they offer? What are the risks and how are the returns? Which is better, investing in bonds or equities? For that, let’s first understand investing in bonds and equity.
Investing in Bonds
Bonds and equities may offer similar advantages but investing in the two is completely different. Bonds are called the instruments of lending. Purchasing a bond is similar to lending money to the issuer of the bond. Since the purchaser of the bond becomes the lender, the borrower (issuer of the bond) pays periodic interest called a coupon to the investor (lender). Hence, investing in bonds can serve as a fixed income source.
It is important to note that every bond has a maturity period, after which the borrower returns the original amount of money. Different bonds can pique the interest of different investors due to the difference in their maturity period. Some bonds have a maturity period of two to three years while some may have periods of maturity up to 30 years. Bonds with higher maturity periods even offer higher rates of return.
Bonds are generally issued by the central government, the state government, local government bodies, or corporate entities. While all bonds are relatively secure investments, government bonds are almost risk-free instruments. The rate of return that is offered on government bonds is even considered a risk-free return. While government bonds are safe investments if compared to equity, the rate of return on bonds is lower than that on equity.
However, there are some bonds that offer returns as high as 50% a year, but they carry a high risk of default, which means that there is a risk that the borrower may not make the required payment. But government bonds do not have any risk of default, however, they do have a significant degree of interest risk. Interest risk basically means that an overall change in interest rate would reduce the value of the bond. As interest rates rise, bond prices fall and vice versa.
Since bonds are flexible, you may be able to make a profit by selling off a bond in a designated market before the completion of the maturity period. Such bonds offer liquidity to investors.
Understanding Equity Investment
By far, we have understood that bonds offer fixed income, flexibility in terms of long-term/short-term investment, and lower risks. Now, let’s take a look at investing in equity. Equity instruments offer two sources of income. Firstly, the investor can make a profit by selling the stock or share whenever its price goes up. Selling at a higher price than the price of purchase helps in booking a profit.
Secondly, equity being the instrument of ownership, where you have become a part of the company, you also reap the benefits of the profits made by the company. Profitable companies pay dividends to their shareholders, which are part of the overall profits. Companies that serve regular dividends even become a source of regular income.
However, return on equity instruments is market-linked and are riskier investments as compared to bonds. The return completely depends upon market conditions and the performance of the company. But at the same time, a higher risk is associated with a higher return and thus the right equity assets have the potential to outperform government bonds.
So, Where Do You Invest?
We have seen different features of both equity and bonds and are aware of the risks and advantages that come with investing in both investment instruments.
Now, to decide where to invest, recognize your investment goal. If it’s a short-term investment, bonds with a shorter maturity period are a much safer option. If you are ready to take some risk even in the short term, high-growth stocks are a more suitable choice as they may generate decent returns in the short term.
On the other hand, the investor with a longer investment horizon may like to invest in equities or long-term bonds. If you are willing to take risks, equities would yield higher returns than bonds. However, the right allocation of money is suggested on the basis of one’s ability to take risks. Perhaps, you should give both of them weightage based on your risk appetite and financial goals.