What's the Difference Between Stocks and Bonds?
A question that I'm asked all the time is what's the difference between stocks and bonds? It's a very basic question, and is perhaps the first thing that you need to understand when starting to invest. That's because stocks and bonds make up the building blocks for most investment portfolios. The percentage that you own of stocks or bonds tends to determine how aggressive or conservative your portfolio is. While it's true that you may have some other assets in your mix that are neither stocks nor bonds, generally speaking, most investment portfolios are comprised of stocks and bonds. So let's break it down.
In general a bond is going to be much more slow and steady than a stock. Think of a bond as a loan really. It's easiest to think of yourself as a bank when you're investing in a bond. By investing you are choosing to loan money to whoever the bond issuer (the borrower of the money) is. When you purchase a bond from a company or from a government you're really lending money to that entity for a period of time, for a specific amount of interest and accepting their promise to pay you interest for that term, and to return your principal at the maturity of the bond. So they're going to pay you interest along the way at the end of the term, they have to return your principal. Because when you're investing in a bond, you're loaning out money, your primary concern is if I loan money to you, do you have the ability to pay me back? As long as the answer to that is yes, I feel pretty good about my investment. My upside tends to be much more limited, but it also tends to be a little more slow and steady than a stock. That's because my primary risk with bond investing is credit risk. Just like being a bank who makes a loan that the borrower cannot repay - if you buy a bond and the bond issuer (borrower) cannot make the payments, you're stuck with a broken promise for an investment. In case you were unsure - that's a poor investment. What happens when an issuer defaults is another story and it depends on the type of bond, whether the company goes bankrupt, etc. but suffice it to say - if you are looking for slow and steady, you should be looking at higher rated bonds. These are governments, entities, or companies who have a history of paying their bills and have sound financials. While that doesn't eliminate credit risk, it can certain limit the likelihood of experiencing it. There are plenty of other risks with bond investing as well, we'll get into those another time. But for today - remember when you invest in a bond you are loaning your money to someone/something based on their promise to repay.
With a stock you're buying ownership in a company, no matter how small the piece you buy. If you buy one share of stock: You're an owner of that publicly traded company. Just like any other business owner, you need revenues to go up. You want profits to go up for the value of your investment to rise. Completely different than investing in a bond. You haven't lent your money to anyone, you decided to invest money directly into a business to obtain a share of ownership in that business. What you see with stocks is that they tend to be much more volatile than most bonds because the market is constantly trying to gauge whether this is a company that's on the rise, whether profits are going to be up or if it's a company that's falling. And so that's the thing that you're looking for with stocks. Like any good business owner your hope is that your business will grow, and your profits will grow along with it, and therefore your company will become more valuable. In addition to stock price appreciation (if a stock goes up) you also have the potential to make a return on your investment if your stock pays a dividend. A dividend is basically a distribution of profits from a company to it's owners. Rather than reinvesting those profits back into the business to fuel additional growth the profits are distributed out via the dividend. We'll dive into the risks of stock investing another time, but for the purposes of understanding what a stock investment is, when you think stock, think business owner.
Cousin Eddie the Landscaper
Let's talk about an individual example to help drive the point home. Let's say that you've got a cousin, let's say cousin Eddie has a landscaping company. One day Eddie calls you up and he says, "Hey I need you to loan me some money, business is great. I want to put on another crew, I need another truck and I need another trailer. Here's the deal: you loan me money. I'll pay X percent for this period of time. It's gonna be great!" If you decide to lend that money to cousin Eddie, it's almost like you've invested in a bond. You're loaning money to the business. They're going to use that money to continue to grow. You're not concerned if they grow. You're just concerned that they can continue to pay you back over time.
Now let's pretend that conversation goes a little differently. Maybe cousin Eddie calls you, and instead of saying, let me borrow money he says: "Hey, business is great. I want to expand. Why don't you invest in the business with me? You give me X dollars. I'm going to buy a new truck. I'm going to buy a new trailer. We're going to get another crew working. And and we're going to make more profits. And so if you invest this money you'll own this percentage of the business." Well now you care very much what the profits of the business are and that they continue to grow because you're an owner in the business. He's not paying you interest anymore. You're an owner. You need the profits to rise very much like with a stock investment. So that's kind of the basics. Think about, are you loaning money to a company or are you investing in a company? That's going to determine how the investment works. That's going to determine the volatility as well as the potential growth in the investment. If you've got questions about anything above or comments feel free to drop me a line! I look forward to hearing from you!