As an investor, you have two main choices for investing in a given company. You can either purchase shares of a company's stock (generally via a brokerage), or you can buy its bonds. Shareholders are those who own stock in a company, whereas bondholders are those who own bonds issued by a company. Both investments offer the opportunity to make money, but there are risks inherent in each as well.
When you purchase a company's stock, you're essentially buying a piece, or share, of that company. As an investor, you have the option to choose from common or preferred stock. If you buy preferred stock, you'll get a higher dividend payment, and your dividends will take priority over those paid to holders of common stock. In exchange, however, you'll forego voting rights in the company.
As a shareholder, you can make money two ways: by selling your stock for a price that's higher than what you paid for it, or by holding the stock and collecting dividends. If a company generates enough of a profit and declares dividends, it will make payments to its shareholders, typically on a quarterly basis. Companies have the option to determine whether they will pay dividends at all, and the rate at which shareholders will be paid.
When you purchase a bond, what you're essentially doing is lending money to a company in exchange for a predetermined amount of interest. Once your bond matures, or comes due, the issuing company will return your principal as well.
As a bondholder, you can make money two ways: by selling your bonds for more than what you initially paid for them, or by holding the bonds and collecting interest payments. Bondholders typically receive interest payments twice a year. Whereas companies are not obligated to pay dividends if they fail to generate enough earnings, bondholders receive fixed interest payments regardless of a company's performance provided that it has the cash on hand to make those payments. Bonds generally have a lower rate of return than stock.
Both shareholders and bondholders face certain risks when they choose to invest in a given company. Those who own stock in a company run the risk of having share prices fall due to poor earnings, negative news related to the issuing company, or general market fluctuations. Furthermore, if a company performs poorly, it may opt not to issue dividends, thus eliminating a source of income for its investors.
Like shareholders, bondholders run the risk of bond values falling due to factors like poor financial performance, negative press, or general market conditions. Additionally, a company might fail to make scheduled payments, including interest payments and the repayment of principal at maturity, if it does not have enough cash on hand to fulfill its obligations as specified in its bond contract. This is known as a default.
Who takes priority?
In the event of a corporate bankruptcy, bondholders take priority in terms of repayment. Once bondholders are paid, preferred shareholders are next in line. Those who own shares of common stock are last to be paid, and for this reason, common stock is generally considered to be the riskiest way to invest in a company, while bonds are considered the least risky. No matter how you choose to invest in a company, however, the potential for monetary loss can't be ruled out.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!