Today's lesson is on something that we have found many people say they know, yet if you were to ask them to explain it simply, they wouldn't be able to- the difference between a share of stock and a bond.
Stocks Are Ownership
Let's say Cindy owns a company that makes Widgets. Her company is doing well- she has a number of local and national accounts that are buying her products, her employees work hard and like their jobs, and things seem to be cruising right along. However, so she can be a player on the national and global levels, Cindy wants to grow her company much more quickly, and her current income stream won't allow her to do so. One way that she can raise capital (money) is to divide the ownership of her company into small pieces, and sell each one of them. In this instance (a super-oversimplified version of an Initial Public Offering, or IPO), Cindy creates "shares" of the company, otherwise known as Stock. These shares of stock are then bought and sold to other people and companies in a number of different manners, which we will get into at another time. Those people (shareholders) can then buy and sell their stock as they wish.
When you buy a share of stock, you then own a small piece of the company. If the performance of the company increases, so do the benefits that you receive as being an owner of part of the company. Most commonly, the shares that you own become more valuable if you were to sell them to someone else. Also, if the company wants to, they can declare a dividend. This is when they decide to return part of the company's profits to all of the shareholders. However, the converse is also true- if the performance of the company declines, so do your benefits. The value of the shares can go down, and chances are no dividends will be sent out.
Since a share of stock is ownership in a company, it is said that the owners of the shares have "Equity" in them- just like if you own part, or all, of your house, you have equity in it.
Bonds Are Loans
One way that larger, typically more complex, companies can raise capital is through the issuance of Bonds. There are a bunch of different types of bonds, which we will also discuss later. For now, lets say that the Orange Computer Company, which is quite large, wants to raise operating capital. They could take on small loans from a lot of different people and organizations, and agree to pay interest on the loans at regular intervals. At some point in the future, Orange would repay the principle that they borrowed, and would no longer need to pay interest on the loans. Each one of these small loans is a Bond.
When you buy a bond, you are loaning the issuing company, government, or organization money. The principle that you give them, normally in $1000 increments, is at a "Par" amount. The company then guarantees that you will receive your interest (called a Coupon) on a regular basis- normally twice per year. So, in bond parlance, if you purchase a 4% bond at a par of $1000, you will get a $20 check every 6 months (4% of $1000 is $40, then split into two payments per year). This continues until the company sends you a check for your initial $1000 and the transaction is completed, or in some really rare cases, goes out of business and defaults on the loan.
Just like with stocks, there are many different ways to invest in bonds- again, a topic for another day. Bonds are normally seen as a safer, less volatile investment than stocks, since there are quite a few regulations around them.
Should I buy Stocks or Bonds?
For the most part, yes.
A well-built investment portfolio usually has both in it. The amount of your portfolio that you should have in either one completely depends on your personal situation and goals*. Definitely seek out the wisdom of an experienced adviser when deciding how much of each to buy. One very general rule of thumb is that stocks are generally better suited for investors that are concerned with growing the size of their portfolio, and bonds are a little bit better for the investor that wants regular income out of their portfolio.
*Investments: Not FDIC Insured – No Bank Guarantee – May Lose Value In general, bond prices rise when interest rates fall, and vice versa. This effect is usually more pronounced for longer-term securities. You may have a gain or loss if you sell a bond prior to its maturity date.