When inflation accelerates, it’s hard to find anything—stocks, bonds, even “junk bonds”—with returns that match rising consumer prices. Stocks, bonds and ETFs each have their pros and cons. In addition, each asset class has dramatically different structures, fees, returns and risks.
Understanding the differentiators that separate these asset classes is critical to building a successful investment portfolio over the long term. Here are the top pros and cons of stocks, bonds, ETFs and trading.
Pros and cons of stocks
Investing in stocks means that you own a share of the company whose shares you are buying. As the company grows, you can expect the shares to generate a return on your investment.
Historically, the stock market has provided investors with generous returns over time, but it can also go down, giving investors gains and losses in terms of risk and return.
Stock investment offers plenty of benefits:
- Make use of a growing economy: When the economy grows, so do the profits of companies. This is because economic growth creates jobs that generate income that generate sales.
- The best way to stay ahead of inflation: Stocks have historically provided generous annual returns over the long term. This means you need to have a longer time horizon. This way you can buy and hold, even if the value drops temporarily.
- Easy to buy: The stock market makes it easy to buy company shares. You can buy them through a broker or financial planner or online. Once you’ve created an account, you can start buying shares in minutes.
- You don’t need a lot of money to start investing in stocks: most retail brokers let you buy and sell stocks without commission. If the shares to be bought are too expensive, you can also buy fractional parts, if the brokerage allows.
Here are disadvantages of investing in stocks:
- Risk: You may lose your entire investment. If the company does poorly, investors sell, causing the share price to fall. When you sell, you lose your initial investment. If you can’t afford to lose your initial investment, buy bonds instead.
- Common shareholders are paid last: Preferred shareholders and bondholders or creditors are paid only if the company goes bankrupt. A well-diversified portfolio should protect you against business failure.
- Time: If you’re buying stocks yourself, research each company to see how profitable you think it is before you buy its stock. You have to learn to read accounts and annual reports and follow the development of your company in the news which of course takes a lot of time.
- Taxes: If you sell the shares at a loss, you may benefit from tax breaks. But if you sell your shares for a profit, you have to pay capital gains tax.
Pros and cons of bonds
The Pros:
- The return on investment is fixed. You get a fixed interest rate and a return on your principal when the bond matures. You know exactly how much you will get back.
- Less risk compared to stocks. In addition to bondholders receiving a certain investment return, they are primarily paid in the event of liquidation, before shareholders.
- More stable. Bonds can fluctuate in value with current interest rates and inflation levels, but are generally more stable than stocks.
- Titles have clear classifications. This gives investors more certainty when choosing a bond, but you’ll probably still want to do your own research and due diligence before investing.
The Cons:
- The return on investment is fixed. While this gives investors more security, it is also a disadvantage because you lose the greatest possible benefits of investing in stocks: receiving a higher return if the company becomes more successful.
- A higher investment value is required. While some bonds can be purchased for relatively small amounts ($1,000), others may require larger amounts.
- Less liquid than stocks. Some bonds may be very liquid, but bonds issued by a smaller, less financially stable company may be less liquid because fewer people are willing to buy them.
- Direct exposure to interest rate risk. Interest rates affect the value of bonds more directly than stocks. If you plan to receive only interest payments and hold the bond to maturity, this may not be a problem for you.
Pros and cons of ETFs
Since their establishment in 1993, exchange traded funds (ETFs) have become extremely popular among investors looking for an alternative to mutual funds. Both institutions and individuals could see the benefits of these instruments: a bunch of assets designed to replicate an index with low management fees and better intraday price visibility.
There are numerous advantages to ETFs:
- Diversification. ETFs can track a wider range of stocks or even try to replicate the performance of a country or group of countries.
- Trade like stocks. While an ETF can provide diversification benefits to its holder, it has the liquidity of stock trading. ETFs, in particular, can be bought on margin and sold short. ETFs trade at a price that changes throughout the day.
- Lower prices. Passively managed ETFs have a much lower expense ratio compared to actively managed funds, which are typically mutual funds.
- Dividends are immediately reinvested. In a perpetual ETF, corporate dividends are immediately reinvested, while in index funds, the exact timing of reinvestment can vary.
While the pros are many, ETFs carry drawbacks too. Among them:
- Less diversification. Investors in certain industries or foreign stocks may be limited to large-cap stocks because the market index has a limited group of stocks. A lack of mid-cap and small-cap activity can keep potential growth opportunities out of reach for ETF investors.
- The daily price may be too high. Long-term investors may have a time horizon of 10-15 years and thus cannot benefit from one-day price movements.
- Costs may be higher. Most people compare trading ETFs to trading other funds, but when comparing ETFs to investing in specific stocks, the costs are higher. The actual commission paid to the broker may be the same but not the inventory management fee.
- Lower yield. There are ETFs that pay dividends, but the returns may not be as high as owning a stock or group of high-yielding stocks. The risk associated with owning an ETF is generally lower, but if the investor can afford the risk, the return on the stock can be much higher.
Pros and cons of trading
Many first-time traders often wonder about a number of issues before they start to trade. People want to know about the ease of trading and compare its returns with other investment classes. Trading has both its advantages and disadvantages.
Here are the advantages of trading:
- Simple and practical. Time is of the essence when trading shares in the stock market, so the quick launch of online trading portals is a boon for many shareholders.
- Good income. For most people who start trading online, the main goal is to quit their job and make a living from the market. If you play strategically and smartly, you can easily earn 18-30% per year.
- Derivatives do not require capital. Derivatives are financial contracts; its value is derived from capital. These can be stocks, indices, commodities, currencies, exchange rates or interest rates.
- Liquidity. Market liquidity reduces risk and gives everyone more options to buy or sell at the price they want.
Here are the disadvantages of trading:
- Unexpected losses. Many people think that trading is the easiest way to make money in the stock market, but it is also the easiest way to lose money.
- High tax liability. A tax liability is the amount of tax received by an industry or an individual under the applicable tax rules. A taxable transaction results in the calculation of the tax liability. Tax liabilities arise from cash gains, real estate auction profits or additional taxable activities.
- Circuits. A circuit breaker is a structure that causes the exchange to malfunction in certain situations. Circuit breakers are only useful in equity and derivative markets.
A well-diversified portfolio includes a wide variety of securities across multiple asset classes. In general, the longer your time horizon (ie, the younger you are), the more risk you can take. Whether you’re investing in bonds, stocks, ETFs or you decide to take on trading, do your due diligence and make sure you have a solid safety net.
