You may have heard people refer to stocks and bonds when talking about their retirement accounts or personal investments. These two products make up the majority of investing activity. How exactly do they work?
A stock is a piece of equity. It is a product you purchase that represents partial ownership in a company. Companies sell or “issue” shares on the stock market for the public to buy. Each share represents one small portion of the company.
If the company does well, then the stock value goes up. This means that the people who bought the shares, also known as shareholders, gain a profit. If the company does poorly, the stock value goes down. This means the shareholders will take a loss.
The stock market allows companies to raise money in exchange for partial ownership of their business. Everyone who buys the shares is considered an investor. The money you put into purchasing the share goes to the company, and the company uses it to run its business.
A bond is a product that represents a loan. It is like an I.O.U. that represents debt from the lender to the borrower, which must eventually be repaid with interest. The basic idea is that a bond is a piece of paper that represents borrowed money.
Each bond contains the details of how much money is borrowed, how much is owed, when the payments are made, and the maturity date when the bond must be paid back in full. Governments and corporations will sell or “issue” bonds to raise money, much like stocks.
The original purpose of bonds was to raise money for war. However, they are also used to build roads, schools, water infrastructure, electrical grids, football stadiums, and all sorts of important projects that require large amounts of money.
For example, consider a government issuing war bonds for $100 at 5% interest with a 5-year maturity date. A citizen can spend $100 to support their country, and in return, they will be paid $105 when the bond matures in 5 years. This sum is typically paid in installments every six months.
Bonds are leading and lagging indicators in the stock market. A bearish stock market leads to divestment into bonds, and a bearish bond market leads to the growth of the stock indices. In this way, bonds can be used to foresee changes in equity.
Before you buy stocks or bonds, there are a few things you should first understand.
Owning stock gives you a chance to profit from increasing prices in shares. If you sell the shares for a greater price than you bought them for, you make a profit. In other words, buy low, sell high. A stock investor wants to invest in healthy companies with promising futures.
The money you make from buying and selling stocks is considered capital gains, and these are taxed differently than a wage or a salary.
Owning bonds gives you the chance to profit from interest. Like any other type of loan, you are making a profit from the interest on lending out your money. As opposed to buying stocks, your income from bonds is interest rather than capital gains.
Depending on your regional laws and where you purchase the bonds, the money you make from owning bonds is often non-taxable. This primarily applies to government bonds.
In financial markets, everything is connected, directly or indirectly. As stocks and bonds are two of the most popular markets worldwide, they have an important relationship.
When the stock market goes down, like in a huge market crash, investors will panic and sell their shares. They will then invest their money in other markets, most often the bond market. So, when stocks go down, bonds go up.
When the stock market is doing well, such as directly after a market crash, investors will put more of their money into the stock market. This means fewer purchases are being made in the bond market. So, when stocks go up, bonds go down.
Each market has its own set of risks. However, in general, bonds are safer and stocks are riskier.
Bonds provide a stable income from the interest on your loans. While bond rates may seem low at first, they can be reinvested and compounded over time. Ultimately, bonds provide a stable and reliable source of income with your savings.
Stocks provide riskier gains from the growth of your investments. Some stocks are riskier than others, but they can provide much higher returns than bonds in general. Investing wisely in the right stocks can multiply your savings. In investing, higher rewards mean higher risks.
Now, you may be thinking, why not buy both?
This is actually a very good idea. One way to reduce the overall risk of your investments is to spread your money across several assets and markets. This is called diversification.
In other words, you don’t need to put all your eggs in one basket. Even within your stock and bond investments, you want to diversify your stocks and diversify your bonds. So if one company or type of bond does not perform well, the other investments can make up for it.
For many, investing is a way to prepare for retirement. The older you are, the more you want to put into safer investments like bonds. That way the bulk of your money is safe as you get closer to retirement age. Inversely, having more money in stocks at a young age will build wealth.
The rule of thumb here is to subtract your age from 120 and use that number to determine the percentage of your portfolio that should be in stocks. So, a 30-year-old would have 90% of their portfolio in stocks and 10% in bonds.
However, this rule of thumb can be adjusted depending on your risk tolerance and the performance of the bond market. These rules of thumb provide simple answers to investing, but the market is anything but simple.
There is a whole world of exciting investments in the financial markets. Many are just below the surface of what the average investor considers. Let’s take a look at a few special types of investments that provide unique benefits.
Instead of waiting to collect interest after the maturity date, you can sell bonds at a higher price than what you purchased them for. The price will go up if interest rates go down or if the risk profile of the issuer improves. However, the retail investor has limited access to this activity.
Not all bond activity is as low-risk and stable as it may seem. Bonds are often very large investments, and the people who trade them can collect very large commissions. Compared to just buying bonds for retirement, trading them can be very exciting.
This is a way to make a faster profit rather than a steady income.
On the other hand, dividend stocks provide a way for investors to make a steady income on stocks as opposed to faster and riskier profits. A dividend stock will regularly pay out dividends, which are a portion of the stock price that is paid in cash to shareholders.
For example, a dividend stock worth $10 may pay out $0.05 in dividends in each period. That means for every $10 stock you own, you will make $0.05 or 5% when dividends are paid out.
This is a way for larger companies, which are not as focused on growth as younger companies are, to attract shareholders. Some of these actually pay out every month, providing a very steady income that could even replace a monthly salary or wage.
A preferred stock is a type of dividend stock that is prioritized or preferred, by the issuer. These stocks pay out higher dividends and are a higher priority for the companies that issue them. In a way, preferred stock is a combination of stocks and bonds.
Like stocks, preferred stocks represent equity. However, much like bonds, they offer a steady income from investments. These are the best stocks to purchase if you want to sacrifice things like voting rights in the company in exchange for increased dividend payouts.
What is the difference between baby bonds vs. preferred stock? A baby bond is simply a bond with a value below $1,000. These bonds will still pay a fixed income for ownership, but they are more accessible to retail investors like dividend stock.