Stocks and Bonds, James Bonds
When you think of the word “stock,” what comes to mind? You may think of the New York Stock Exchange. Or, maybe (if you’re like me), you think about how much you need to stock up on Peppermint Ice Cream before it goes out of stock again after the holiday season (just me?…okay).
What about bonds? Do you picture a strapping Daniel Craig wearing a pristine black tuxedo, casually armed with a Walther P99 pistol, in hot pursuit of a criminal? Because I sure do.
No matter what comes to mind, we’re going to dive in to the definitions of stocks and bonds (the financial kind, sorry Daniel Craig), discuss what they are, and why they are important to us.
Let’s start with stocks. By definition, a stock is a type of financial security that allows the stockholder the right to ownership in a company. When someone purchases a company’s stock, they are buying a piece of that company, including the right to claim a portion of the company’s earnings (if they have any — aka if the company makes any money, which you sure hope they do if you invested in them).
Think of stock like a piece of pizza. Say you and three other friends are hanging out on a Saturday night and suddenly the midnight munchies strike.
All four of you decide to put in 2 bucks per person to buy a medium pizza for $8. When the pizza arrives, each person owns the right to ¼ of the pizza (or 2 pieces each), since you each contributed $2 for an $8 pizza with 8 slices total. #Math
Now, obviously a pizza can’t magically grow in size. But for this example, let’s say that it can. Imagine the pizza miraculously doubles in size. Now, you own the right to 4 slices of pizza! Well, since you’re on a diet and you really shouldn’t eat more than two slices of pizza, you decide to sell those two extra slices to a new friend who (conveniently) stopped by after you all ordered the pizza.
In theory, this is how buying a stock works. You own a portion of the company. When the company grows and earns profits, you are entitled to a percentage of those profits. You can then sell your portion of ownership in the company to someone else for more than you originally paid for it. By the way, that’s the ONLY way to make money with a stock — the company must grow so that you can sell your portion for more than you bought it for.
What happens if the company loses money and the stock price goes down? Well, that’s the risk of investing — which is especially risky if you invest in just ONE company or sector of the market. If the one company you invested in (Target, for example) or sector of the market (all retail stores), suddenly goes out of business (don’t panic…this is just a hypothetical example), then you would lose all of your money very quickly. Thankfully, investors have alternative options, such as mutual funds, that allows you to invest in many different companies across many different market sectors at one time — thus limiting your overall risk.
Okay, so now that we know what a stock is and how it can earn us money, let’s talk about bonds. Sorry, we’re still not talking about you, Daniel Craig.
Unlike stocks, bonds do not represent ownership in a corporation. Instead, bonds are a type of loan that an investor can make to a company or to the government, which in turn, promises to return a fixed interest rate to the investor over a specific period of time. Ideally, at the end of the bond’s lifetime, the investor will be repaid her entire initial payment, plus a fixed rate of interest. This is why bonds are often called “fixed-income securities” — because they provide a fixed amount of income (in the form of interest payments) to the investor. Shocking, I know.
Because bonds promise to pay back your initial investment plus a fixed interest rate, they are said to be less risky than stocks, which do not have a fixed rate of return and do not promise to return the money invested. However, bonds are not completely risk-free. The amount of risk you take with a bond depends largely on who is borrowing your money. In real world terms, you know that it’s a lot less risky to loan your mom a dollar than that one friend who is a notorious mooch and never pays anyone back. (I’m talking to you, Karen).
Applying that same concept to investing, a bond issued by a young, relatively unstable company is much more risky than a Treasury bond, which is issued by the federal government and is essentially risk-free. Why is a Treasury bond risk-free, you ask? Well, the federal government has this amazing authoritative power called TAXATION, which means it can always raise taxes in order to pay back the interest on its Treasury bonds. As much as a normal company would simply LOVE to force its customers to buy their products (or else!), unfortunately, they can’t do that. This means that corporate bonds may not always be able to keep their promises of paying the investor a fixed interest rate, thus creating risk. Usually, the more risky the bond, the higher the interest rate will be. On the flip side, Treasury bonds usually have the lowest interest rates on the market. Low risk, low returns. High risk, high returns. You get it.
Believe it or not, we’ve just barely scratched the surface of stocks and bonds. Tragic, I know. I don’t want to bore you to tears, so we’ll leave it at that for now.
But, before you go, one last question. Why do stocks and bonds matter? Even if you don’t plan on being the next Warren Buffett, you should feel confident in understanding stocks and bonds, and identifying where they fit into your investment portfolio (Note: If you’ve got a 401(k) or retirement savings plan, chances are you’re already investing in several stocks and bonds, whether you realize it or not. Congratulations!)
(QUICK DISCLAIMER: I am NOT a financial professional, so please consult one of those fantastic, educated, and far-more-qualified individuals BEFORE you dive into investing or making changes to your retirement plan). As a very general rule of thumb (not specific to every individual’s situation), the younger you are, the more your money may be invested in stocks and less in bonds. As you age and grow closer to retirement, the percentage of your money invested may gradually shift from stock-heavy to bond-heavy. The reason for this is, when you’re young, you have the advantage of time on your side to ride the up-and-down roller coaster of the stock market. Even when there is a market correction and you lose a portion of your portfolio, you still have decades before retirement to earn that money back. However, the closer you get to retirement, the less time your portfolio has to bounce back after a market correction. Thus, safer investment options like bonds will help prevent you from losing your entire life savings to a market drop right before you were planning on retiring and moving to Hawaii. AloNAH, you don’t want that to happen.
Alright, now you know what stocks and bonds are and why they matter! Woot woot! Next step, consult with your financial professional to collaborate on an investing plan that is specifically designed to meet your lifestyle goals.
And, don’t forget to check back here for new, exciting content to be released very soon!
Written By: Kaitlyn Duchien (@ktaylor1395)
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