Stocks vs Bonds vs Savings Accounts
Stocks, bonds, and savings accounts are an effective way to generate a steady, long-term income; keeping your money tucked away for a rainy day and earning extra cash in the process.
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The rate you earn, the benefits offered, and the ways you can access your money all differ depending on the option chosen, and in this guide, we’ll compare all of these features and more to find the best option for you.
The Basics: What are They?
Before we look at the difference in interest rates and accessibility, let’s get the basics out of the way, what are stocks, bonds, and savings accounts?
- Stocks are shares of a company owned by investors. The company posts on the stock market, making its shares available to the general public, and investors can then purchase them at a price set by the market. Owning stock entitles you to vote on important company decisions and receive dividends, which are cash sums paid to stockholders.
- Bonds are essentially I.O.U’s between a company a borrower, with the former using them to finance projects and the latter acting as their creditor. The bond will state when the amount is due to be returned and what kind of variable or fixed rate of interest is paid. As a consumer seeking to save some cash, the only thing you need to remember is that bonds can be offered by companies or the government and pay a sum of interest on your investment.
- Savings Accounts are provided by banks and credit unions. They are basically checking accounts that pay a rate of interest. The lender uses this money to fund loans, from which they receive even higher rates of interest.
What Do You Need to Open These Accounts?
A savings account is one of the easiest accounts to open as you only need a government-issued ID, and some basic information, such as your Social Security Number. The application process is even quicker and easier if you already have a checking account with the lender.
To buy stock, you need a stockbroker or online brokerage account. The latter is much easier and cheaper and gives you more control over your investments. To open a brokerage account, you need many of the same details required for a bank account and the process is similar as well.
You will be charged a fixed commission when you purchase stocks through this brokerage account and can transfer money via a bank account to ensure you have the funds.
To purchase bonds, you need a U.S. bank account, U.S. address, and a Social Security Number. You can purchase bonds through a brokerage account, via the U.S Treasure Department or via an Exchange-Traded Fund (ETF).
The Best Return on Your Investment
A savings account provides the most reliable rate of return. You can earn anywhere from 0.5% to 2% per year, with the average being around 1%. This is very low when compared to bonds and stocks, but it’s also stable.
Your money is insured for up to $250,000 by the FDIC, which means that even in the unlikely event that something goes wrong, you will be covered. If we assume that you have $10,000 to invest right now and an additional $500 per month, you will have $42,550 at the end of a 5-year term, $2,550 of which is interest.
As for bonds, the rate is around 4% on average, which essentially doubles the rate of investment quoted above, earning you more than $5,000 in interest during a 5-year term.
Finally, stocks have earned an average annual return of 11% over the last century or so, with more peaks than dips and more increases than decreases.
For every depression and recession, there are several periods of economic prosperity.
It would be careless to assume that you could get the same rate of return over the next few years, but many experts, including Warren Buffet, predict that you can get an average rate of 6% per year. With the same calculations as above, stocks would earn you $48,125 during that 5-year period, $8,125 of which is interest.
It’s the best option based on profitability alone, but it’s also a high-risk option so there’s much more to consider than profitability.
The Most Accessible
Arguably, savings accounts provide you with the easiest way to access your money. Traditional savings accounts allow you to withdraw money several times a month without incurring any fees, although you may be hit with fees and restrictions with long-term savings accounts like Certificates of Deposit (CD).
If you have your savings account connected to a checking account, you can move money back and forth at will. However, this can be a negative, as it tempts you to spend money that would otherwise be reserved for emergency purchases.
Bonds typically incur penalties if you withdraw them early. The bond will state when it can be cashed without issue, often after at least 12 months have passed.
As for stocks, these are perhaps the least liquid of all. If you have an online brokerage account, you can cash your shares during an active trading day and then wait a few days for the money to reach your bank account. In most cases, it will likely hit your brokerage account first and then need to be withdrawn to your bank account from there.
The problem is, if you cash out early because of an emergency, you stand to lose some money. Firstly, all stock purchases incur a commission charge and you may also be hit with withdrawal fees. If you purchase $1,000 worth of shares and pay $50 in commission/fees, that means you’re paying 5% in fees.
To avoid a loss, you need to cash those stocks when they have gained at least 5% profit, which may take weeks, months, or not happen at all. What’s more, you may need to wait many months before you start earning dividends, assuming your chosen stock pays dividends at all, and without this profit you’re almost guaranteed to take a loss if you cash your stocks within the first few months.
Summary: Stocks vs Bonds vs Savings Accounts
With all things considered, which option is best?
In truth, it all depends on how much money you have to invest, whether there is a chance you will need emergency access to that money, and what you’re saving for. Of course, that’s probably not what you wanted to hear, so let’s simplify things a little.
A savings account should be your first port of call. The rate of interest may be low, but your money is safe, will not be impacted by market fluctuation, and will remain even in the event that the economy goes into freefall. What’s more, if you’re hit with an unexpected bill, you can simply tap into that savings account and use the money as needed.
Once you have some money saved, you can think about stocks and bonds. How you want to split your remaining budget is entirely up to you, but there are a few important things to remember when investing in stocks.
Firstly, stick with blue-chip companies, as they are the ones that pay dividends and your money will be safer there than with penny stocks. Secondly, while it’s important not to place all your eggs in one basket, you shouldn’t be tempted to split your cash too much.
First-time investors often spread their money around, choosing to invest $1,000 into four or five companies instead of one. However, if you’re paying $40 commission on a $200 investment, that means you’ve lost 20% straight off the bat and need the stock to improve by the same amount before you start earning a profit.
Commission often remains the same regardless of the amount you invest, however, so if you increase that to $2,000, 20% becomes 2%.
Most importantly of all, remember to keep these investments in the back of your mind.
Don’t stress over them, don’t feel like you need to check every day, and don’t be tempted to cash as soon as they grow by one or two percent.