The difference between shares, ETFs and bonds

Shares, ETFs, bonds - many terms from the world of finance sound more complicated than they actually are. This article explains the key basics of investing in simple terms, without making any recommendations and without using jargon.

What exactly are shares, ETFs and bonds?

Certain terms crop up time and again in discussions about investing. Three of them appear particularly frequently and, for many people, mark the starting point for exploring the topic of investing. These are shares, ETFs and bonds. All three are classified as securities, but differ significantly in how they function. To understand the difference, it helps to consider the nature of the capital commitment.

Shares as equity

A share is a stake in a listed company. Anyone who buys a share acquires equity and thereby becomes a shareholder with certain membership rights, albeit on a very small scale. The potential return on shares consists of two components. Firstly, capital gains when the value of the share rises. Secondly, potential profit distributions, known as dividends. Whether dividends are paid and in what amount depends on the company in question and can vary from year to year.

As a co-owner, you bear the full business risk. The value of a share can rise significantly within a short period, but it can also fall significantly. In the worst-case scenario, such as if the company goes into insolvency, you could lose all the money you have invested.

Bonds as debt capital

A bond, also known as a debt security, operates on a fundamentally different principle. Anyone who buys a bond provides the issuer with debt capital, effectively granting a loan. The issuer may be a company, but it may also be a government.

In return, the buyer often receives a fixed annual interest payment, known as a coupon. However, there are also bonds with variable interest rates or those that do not involve any regular interest payments at all. At the end of the agreed term, the original amount, known as the face value, is repaid.

Bonds are generally considered less volatile than shares. However, this does not mean that they are risk-free. Bonds also carry various risks, which will be discussed later in this article.

ETFs as a bundled investment

The abbreviation ETF stands for Exchange Traded Fund. An ETF is an investment fund that is traded on the stock exchange and usually passively tracks a specific index. An index is a kind of list that tracks the performance of a specific group of companies or markets. A well-known example is the DAX, which tracks the share price performance of the 40 largest listed companies in Germany.

Instead of selecting individual securities yourself, investing in an ETF means investing in a pre-defined basket comprising many different securities, often hundreds or even thousands. This bundling automatically results in a certain degree of diversification. Nevertheless, ETFs can also lose value, for example if an entire market or sector performs poorly.

One aspect frequently mentioned in connection with ETFs is their status as special funds. In many funds, such as those compliant with the European UCITS standard, the fund’s assets are legally separated from the assets of the fund management company. This is intended to help protect the invested capital in the event of the company’s insolvency. The specific details, however, depend on the individual fund and the applicable legal framework.

What is the key difference?

Put simply, the core of the difference lies in the nature of the investment. Anyone who buys a share becomes a shareholder and bears entrepreneurial risk. Anyone who buys a bond becomes a creditor and provides capital that is to be repaid. An ETF, on the other hand, is a fund whose units are traded on the stock exchange. It bundles together various securities, often shares, sometimes bonds, or a mix of both.

What does risk mean in the context of investing?

The term ‘risk’ is used constantly in the financial world, yet for many people it remains difficult to grasp. In everyday life, risk is often equated with danger. When it comes to investments, the meaning is somewhat more nuanced.

Fluctuations as an expression of uncertainty

In the context of investments, risk primarily describes the possibility that the value of an investment will develop differently than expected. This can happen in either direction. The value may rise more sharply than anticipated, but it may also fall. These fluctuations are referred to in technical terms as volatility.

The more an investment’s value fluctuates, the higher its risk is assessed to be. Shares generally fluctuate more than bonds. ETFs fall somewhere in between, depending on their composition, but pure equity ETFs tend to lean more towards the share side.

Different types of risk

In addition to general price fluctuations, there are other, more specific risks, the severity of which can vary depending on the type of investment.

With shares, the key risk is business risk. If a company performs poorly or becomes insolvent, the value of the share may fall sharply or, in the worst-case scenario, be lost entirely.

With bonds, two risks in particular come into play. Issuer risk describes the possibility that the issuer of the bond will fail to meet its payment obligations. In addition, there is interest rate risk. If general market interest rates rise, the prices of existing bonds usually fall, as their fixed coupon becomes less attractive compared to new bonds with higher interest rates. Anyone wishing to sell a bond before maturity may incur losses in such a case.

With broadly diversified ETFs, a total loss is significantly less likely than with a single share, but cannot be completely ruled out in theory. The specific risks of an ETF depend on the securities it contains.

Risk is not just a number

It is important to understand that risk is not just a mathematical quantity. It also has a very personal side. How much volatility someone can tolerate without becoming nervous or making hasty decisions depends on many factors. These include one’s own financial situation, personal experience with investments, and also one’s general need for security. What one person finds tolerable may already cause unease for another.

Spread and diversification

The basic idea behind diversification

Spreading, known in technical terms as diversification, is one of the most frequently cited basic principles of investing. The idea behind it is simple. Anyone who spreads their money across different investments is less dependent on how a single investment performs.

A vivid illustration of this is the saying “Don’t put all your eggs in one basket”. If a basket falls, not all the eggs are affected, provided they have been spread across several baskets. Applied to financial investments, this means that losses in one area can be at least partially offset by more stable performance in other areas.

Different levels of diversification

Diversification can take place at different levels. It is possible to diversify within a single asset class, for example by holding shares in different companies. It is also possible to diversify across different asset classes, such as combining shares and bonds. Furthermore, diversification can be achieved across different regions, sectors or currencies.

ETFs, in a sense, apply this principle by design. Anyone buying a broadly diversified ETF automatically invests in a wide range of securities, thereby achieving a certain degree of diversification within that particular asset class. Depending on the ETF, this diversification may encompass a few dozen, or even several hundred or thousand individual securities.

What diversification can and cannot achieve

By spreading investments widely across different assets, so-called unsystematic risks can be reduced. These are risks affecting individual companies or sectors, such as the insolvency of a specific company. However, diversification cannot eliminate all risks. If the financial markets as a whole fall sharply, broadly diversified investments are usually affected too. In this case, we speak of systematic risk, i.e. the general market risk that cannot be eliminated by diversification alone.

Typical cost terms in financial investments

Why costs matter

Costs can arise with any financial investment. These costs reduce the return, i.e. the profit that remains at the end. It can therefore be helpful to have at least a basic understanding of the most common cost terms.

Buying and selling fees

When buying or selling securities, fees are usually incurred, which are also referred to as order fees or transaction costs. These fees are charged by the bank or provider through which the purchase or sale is processed. The amount may vary depending on the provider and the type of security.

The TER for funds and ETFs

A term that comes up particularly frequently in connection with ETFs and other funds is the TER. The abbreviation stands for Total Expense Ratio. The TER indicates what proportion of the invested money is spent annually on the management of the fund. This amount is not invoiced separately, but is taken directly from the fund’s assets, which affects its performance.

The TER typically includes management fees, the costs for the fund’s custodian bank and other ongoing expenses. However, not all costs are included. Transaction costs within the fund or potential taxes are generally not covered by the TER.

Differences in the cost structure

Costs can vary considerably depending on the investment form and product type. ETFs that passively track an index do not require an active fund manager to select individual securities. This typically results in lower ongoing costs. Actively managed funds, where a fund manager makes specific investment decisions, generally have a higher TER. In addition, active funds may incur so-called front-end loads, i.e. one-off fees when purchasing fund units, which are not usually charged for ETFs.

Custody fees

Securities are held in a so-called custody account, comparable to a bank account set up specifically for securities. Fees may apply for the maintenance of such an account. Whether custody fees are charged and, if so, how much, depends on the respective provider.

What investment costs mean

Costs have an impact over the entire duration of an investment. Even if individual amounts seem small, they can add up over the years and have a noticeable effect on returns. It can therefore be useful to understand the cost structure of an investment before deciding for or against a particular product. If you are unsure, independent advice can help.

The time horizon as a concept

What is meant by ‘time horizon’

The time horizon describes the period for which an investment is intended. In other words, it refers to how long the invested money is expected to remain invested before it is needed.

Why the time horizon matters

The time horizon influences how fluctuations can affect an investment. Over short periods, value fluctuations carry greater weight, as there is less time to offset potential losses through a subsequent recovery. Over longer periods, short-term fluctuations may lose significance, as markets have historically tended to recover over extended phases.

This does not mean that a long time horizon rules out losses. Past performance does not guarantee future results. The time horizon is merely one factor among many that can play a role in assessing opportunities and risks.

Time horizon and stage of life

In the second half of life, the time horizon changes for many people. Those who are already retired or about to retire generally have a different timeframe to someone who still has several decades of working life ahead of them. This can affect which investment forms are suitable and how much volatility seems acceptable. As this assessment depends heavily on the individual case, personalised advice can be particularly useful here.

Common misconceptions and myths

There are a number of assumptions surrounding the topic of investing that are widespread but not necessarily accurate. Some of these can lead to misjudgements.

“Shares are only for the rich”

This perception stems from a time when access to the financial markets was indeed more complicated and costly. Today, it is generally possible to invest in shares or ETFs with relatively small amounts. Whether this makes sense in a particular case depends on the individual’s personal circumstances.

“Bonds are always safe”

Bonds are often described as a “safe” form of investment. This is true in the sense that they generally fluctuate less than shares. However, it does not mean that bonds are risk-free. As already described, bonds can also lose value, whether due to changes in interest rates or a default by the issuer.

“Investing is the same as speculating”

In everyday language, investing and speculating are often treated as the same thing. In the financial world, however, there is a difference. Investing is generally associated with a longer-term approach, where a conscious decision is made based on information. Speculating tends to describe short-term decisions that are strongly focused on price gains within short periods of time. The boundaries are blurred, but the underlying approach differs.

“You have to time it right”

The notion that there is a perfect time to buy or sell persists. However, numerous studies and practical experience show that reliable timing is extremely difficult in the long run, even for professional investors. Experts therefore often emphasise that the duration of the investment is generally more important than the timing of entry. Here too, however, this is not a universal rule and individual circumstances always play a role.

“Dividends are free money”

A widespread misconception concerns dividends. They are often perceived as a kind of bonus on top of the share value. In reality, however, a dividend payment is a withdrawal from the company’s assets. Around the so-called ex-dividend date, the share price is typically adjusted by the amount of the dividend, although the actual price is also influenced by supply and demand. The investor’s assets do not therefore change fundamentally as a result of the dividend alone; they are merely converted from one form (share value) into another (cash assets). The tax treatment and long-term impact may vary depending on the situation.

“ETFs are complicated”

At first glance, ETFs can seem complex, particularly when terms such as TER, replication method or tracking difference are mentioned. The basic idea, however, is relatively simple. An ETF bundles many securities into a single product and tracks the performance of a specific index. At its core, the principle is no more difficult to understand than that of a savings account, even if the way it works is, of course, different in detail.

Note

This article is for general information purposes only and does not constitute individual legal, tax or financial advice. Despite careful research, no guarantee can be given as to the topicality, completeness or accuracy of the information. For decisions in individual cases or regarding specific questions, it is advisable to seek advice from qualified professionals, such as a solicitor, a tax adviser or a consumer advice centre.