Stocks and bonds are the two basic asset classes (types of investments). This page explains why stocks are generally considered riskier than bonds.
You can lose all in either stocks and bonds
The common sense understanding of risk is the likelihood of losing part or the whole of our investment.
When you buy a stock, in the worst case the company will go bankrupt and the shares will become worthless.
When you buy a bond, the worst case is that the issuer won't have enough money to repay it when due.
You can lose all your money with either stocks or bonds. From this perspective, both seem to be equally risky.
However, the probability of losing your entire investment is much greater with stocks than with bonds, other things being equal.
Let's say you have $10,000 and want to invest it in a company (let's call it XYZ Inc.). You can either buy $10,000 worth of XYZ shares or $10,000 worth of XYZ bonds (the bonds will mature in five years – that is, five years from now you expect the company to pay you your $10,000 back, plus some interest). Which should you buy?
Your relationship to XYZ Inc. will be very different with stocks and bonds.
Bond holder is creditor
When you buy bonds, you become a creditor of the company. As a creditor, you lend the company your money for a certain time (in our example five years) and the company is liable to return that money, plus interest, at that future point of time.
It is the same as when you take a loan from your bank – first you get the cash and at some point in the future, you must return the cash, plus interest, to your bank. If you can't pay it back in time, you can get in trouble and may eventually have to declare bankruptcy.
When you buy bonds it is the same, only now you are the bank and XYZ Inc. owes you money. If the company doesn't have enough cash to repay you, it may have to sell some of its assets, or in the worst case, declare bankruptcy.
Shareholder is co-owner
When you buy shares, you become a co-owner of the company. There is no maturity date – unless you decide to sell your shares, you will own a part of the company forever. You will be entitled to your share of any future profits (however small or big they are), typically paid as dividends.
The key point is, before any dividends can be paid to shareholders, the company must pay its dues to all other parties, including bondholders. If there is not enough cash, the bondholders still get paid first and the shareholders get nothing.
Bondholders get paid first. Shareholders take what is left.
There are three possible scenarios:
Company is profitable
In the first scenario, the company does well and its profits grow. When bonds mature, the bondholders get their principal plus interest, so their investment has worked out well. The shareholders get dividends, plus the stock price goes up, because everything is good. This is the ideal scenario. The better the company does (higher profits), the better for the sharesholders (higher dividends, stock goes up). However, the bondholders won't get more than their principle plus interest – their upside is capped.
Company makes a loss
In the second scenario, the company only does so-so. It is struggling a bit, makes a small loss, but still has enough cash to repay the bondholders in full, principal plus interest, when the bonds mature. However, there are no profits to distribute and therefore no dividends for shareholders. With less than favorable developments, the stock price also struggles. It goes down a bit, so the stock holders see their investment lose a bit of value. The outcome for the bondholders is still the same as in the first scenario. The stock holders are worse off.
Company goes bankrupt
In the last scenario, the company makes big losses and when the bonds mature in five years, it finds its assets not big enough to pay off its debt. It goes into bankruptcy. In the process, it is found that the cash left on the company's accounts is only enough to repay 60% of the debt outstanding. The $10,000 bond investor from our example will only get $6,000 back – a big loss, but at least the bondholder got something back. The stock holder, on the contrary, loses his entire investment. After the bonds have been (at least partially) repaid, there are no assets left in the company and the shares are basically worthless.
Bigger differences in stock outcomes
In sum, in any of the three scenarios, the stock holder's outcome is more extreme than the bond holder's. If company makes big profits, shareholders also make big profits, theoretically unlimited. The bondholder's gain is limited to the interest, which is generally independent of the company's well-being. If the company gets in trouble, the bondholder is always being repaid before the shareholder is – as a result, the stock holder always has at least the same, and often higher, risk of losing money.
This is why stocks are risker than bonds. The outcome for a stock investor is much more closely dependent of how well the company does, while the outcome for a bond investor is more or less constant, unless things go really wrong (and in that case, it is even worse for the stock holder). This is also why stock prices tend to be more volatile than bond prices.
Some bonds are riskier than others
One final note: not all bonds issued by the same company have the same risk.
Firstly, different bonds from the same issuer may have different hierrarchy in terms of the order they get repaid when the company gets in trouble. Bonds which are entitled to being repaid first are generally less risky than those to be repaid after them (the latter are called subordinated bonds), because it may happen that there is not enough cash left.
Secondly, the longer the time to maturity, the riskier the bond is. When a company is doing well today, the probability of it being unable to pay its dues one year from now is relatively small, while the outcome twenty years from now is much less certain. Furthermore, there is one more component of a bond's risk which we haven't discussed yet. Besides the issuer's ability to repay its debt (credit risk), bond prices also depend on interest rates (interest rate risk).
In general, prices of bonds with longer time to maturity are more sensitive to interest rates than short-term bonds, because over the longer period the difference in interest rate translates into a much bigger dollar amount. Note that interest rates and thereby price fluctuations are a concern only if you decide to sell your bonds before maturity; if you intend to hold the bonds until maturity, you only need to worry about credit risk (the issuer's ability to repay).