Stocks and bonds: these two investment vehicles are often confused. Yet, these two instruments form the foundation of many portfolios, whether held by individuals or institutions. What's the real difference between a stock and a bond? What are their returns, their risks, and under what conditions should one be preferred over the other? We'll break it down and offer advice in this article.
Stocks: A Title of Ownership in a Company
What is a Stock?
A stock is a title of ownership. When an investor buys a stock, they effectively become a shareholder in a company, meaning a co-owner, even if infinitesimally, of that company. In return, they acquire a set of rights: a right to dividends, a right to vote at general meetings, and a right to information about the company's life and results.
Stocks are traded on stock markets. Their price – or more precisely, their quote – fluctuates according to the dynamics of supply and demand. But several factors influence the ratio between supply and demand: the economic outlook for the country and the company's markets, its financial results, of course, and also the broader geopolitical climate.
An investor who buys stocks can generate financial gains either by:
- Receiving dividends, which are a portion of the profits redistributed to shareholders;
- Realizing a capital gain upon resale.
By investing in a portfolio of company stocks, an investor bets on their future growth, on their potential for commercial and financial growth and performance. They are, in a way, betting that these companies will perform in their markets through various levers: their competitiveness, their capacity for innovation, a regular increase in demand for their offerings, or the internationalization of their activity.
Stocks Offer High, But Naturally Uncertain, Return Potential
Stocks are known for their ability to generate attractive returns over the long term. Several studies demonstrate this. A stock portfolio held over a 40-year period – between 1982 and 2022 – generated an average return of over 10%. Another study states the same: +10% long-term return. However, this is an investment horizon of several decades. Because in the short or very short term, investing in a stock portfolio means taking into account the potentially high volatility intrinsic to this type of investment. Company prices can indeed fluctuate significantly over short periods.
The investor therefore accepts to consider the uncertainty inherent in how a stock operates.
What is a Bond?
A bond is a debt instrument. By buying a bond, the investor literally lends money to an issuer – a company, a state, a local authority, or even an institution like the European Investment Bank.
In exchange, the issuer commits to:
- Paying regular interest – called the coupon – throughout the life of the bond;
- Repaying the initial capital invested at maturity.
The difference between a stock and a bond, the distinction between these two investment vehicles, lies in the fact that by buying a bond, the investor becomes a creditor and not an owner, as in the case of a stock.
Bonds are Less Volatile Than Stocks, But for Lower Returns
Bonds are generally perceived as more stable assets than stocks. Their volatility is indeed lower, especially when the issuer is a state or a reputable institution. However, their medium-term return is also lower. Over 10 years, it averages 3% or even 4%.
However, while investing in bonds is presented as being more stable than investing through a stock portfolio, there are still risks: default risk and, above all, interest rate risk. Because when market interest rates rise, the value of already issued bonds tends to fall, as they become less attractive than new issues. Conversely, a drop in rates increases the value of outstanding bonds.
What Are the Advantages and Disadvantages of Investing in Stocks Versus Bonds?
Advantages of Stocks
- Potentially high returns over the long term
- Participation in company profits via dividend payments
- High liquidity on stock markets
Disadvantages of Stocks
- Significant volatility: while the price can rise rapidly, it can also fall in the short and medium term.
- Risk of capital loss
- Skills in micro and macroeconomic fundamental analysis are required from the investor
Advantages of Bonds
- Receipt of fixed and regular income via coupons
- Lower volatility than stocks
Disadvantages of Bonds
- Limited returns, often lower than stocks over a long period
- Sensitivity to interest rates, with a direct impact on prices
- Inflation can erode the real value of coupons
- Risk of default by the issuer – especially for corporate bonds
Stock or Bond: In Which Situations Should One Be Preferred Over the Other?
The choice between investing in stocks or bonds depends primarily on the investor's profile, their time horizon, and their patrimonial goals.
For a Young Investor and/or One Willing to Absorb a Dose of Risk
A young investor, who plans to save over a long-term horizon – several decades – and who is also willing to show risk tolerance, can prioritize stocks. The goal is to grow their capital in the long term, while accepting volatility.
For a Cautious Investor or One Nearing Retirement
Conversely, a cautious investor or one with regular income needs may prefer bonds, or even hybrid products (bond funds, convertible bonds).
For a Balanced Portfolio
With a view to diversifying one's investment portfolio, combining both asset classes is often the most recommended strategy. According to the well-known rule of thumb for wealth managers, the proportion of bonds in a portfolio could correspond to the investor's age (for example, 40% at 40 years old, 70% at 70 years old).
Taxation of Stocks and Bonds
Taxation of Stocks
Dividends and capital gains on stocks are subject to the PFU (Prélèvement Forfaitaire Unique) – commonly called "Flat Tax" – at a rate of 30%. It is possible to opt for taxation according to the income tax scale, with a 40% allowance on dividends. Investing via a PEA (Plan d'Épargne en Actions) allows for tax exemption on capital gains (excluding social security contributions) after 5 years of holding.
Taxation of Bonds
Interest received is also subject to the 30% PFU. Also, certain tax wrappers like life insurance allow for tax optimization after 8 years, particularly on euro bonds or bond funds.
So: Stock or Bond?
For many investors, stocks and bonds form two sides of the same portfolio coin. One embodies capital dynamics, the other income stability. One is based on the possibility of a price surge, the other envisions scheduled repayment. Each has its place, provided one understands its nature, its risk profile, its remuneration method, and its tax constraints.
