Why does this matter?
For the average investor, stocks and bonds are the main investments that are easily accessible and common. Understanding stocks and bonds alone will not make you wealthy, but understanding them will help, and failing to understand them will create an Everest-size speed bump in your financial journey.
What is a stock?
Stock is defined by investopedia.com as “a security that represents the ownership of a fraction of a corporation.”
In non-dictionary English, this roughly translates to “owning stock means that you own part of a company.”
*For more on Stock, check out investopedia.com.*
What is a bond?
A bond is defined by investopedia.com as “a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental).”
In essence, a bond is a loan. When you buy a bond, you are loaning money to the company/government, and in exchange, they are agreeing to pay you back by a certain date, as well as pay you interest.
For more on Bonds, check out investopedia.com.*
What does this look like in real life?
Stocks and bonds are both a way for companies to raise money. For instance, let’s pretend that your son starts a landscaping company. He starts off with your old push mower and mows a few lawns on your street. Over time, word spreads that he’s doing an amazing job, and the business grows.
One day, he comes to you and explains that he wants $25,000 to buy a truck, trailer, and bigger mower. The new equipment will allow him to make an extra $50,000 a year, but he doesn’t have $25,000. Fortunately, you have $25,000 that you’re willing to offer him. You have two options that you offer him:
-Option A: You can loan him $25,000, and he will have to pay it back within two years, plus pay you 5% interest. (Buying bonds)
OR
-Option B: You can offer him $25,000 to buy 10% of his company. (Buying stock)
So what does that mean for me as an investor?
If you choose Option A and give him the loan, you make money from the 5% interest that he’s paying you. You get that 5% interest per year regardless of whether his business becomes a huge success or just barely scrapes by, so you know exactly what you’re going to end up making. After two years, the loan matures, and assuming that his business didn’t go bankrupt, you end up with your original $25,000 (which is called the principal) back, plus $2,500 of interest ($25,000 loan x 5% interest x 2 years).
If you choose Option B and buy part of his company, your return depends on how the business fares. If the business flops, your investment will become worth less than $25,000, and it could become worthless if the business goes bankrupt. If the business takes off, the business will be more valuable than when you bought it, and your return will be 10% of however much the value increased. This does not put extra cash into your pocket until you sell your portion of the business, but if the business does well, there is no limit to how much you can potentially make.
Another way that you can make money is if your son decides to pay the owners of the company from the profits that are made. For instance, let’s say that the business ends up making $75,000 with the new equipment. Your son can decide to take $25,000 of the profits and pay the owners of the company (you and your son). This is called a dividend. Because you own 10% of the business, you would get 10% of the $25,000 being paid out ($2,500). Dividends can be paid as often as desired by the Board of Directors of the company, or not at all.
The path that best suits you depends on your financial needs and how you think the business will fare. Buying stock offers much greater potential reward, but is riskier because you’ll lose money if the company doesn’t do well. Buying bonds offers lower risk and lower potential reward because no matter how the company fares, unless it goes bankrupt, you get the principal amount plus the interest.
Stocks and bonds, along with other investments like ETFs and mutual funds through a brokerage company, which is a financial company that acts as the middle man for buying, selling, and holding onto your investments.
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