The Basics of Stocks and Bonds

Stock – Stock represents an ownership share in a particular company. If you own a stock and the company is doing well, you should profit by the price moving up (also known as capital gains). If the company has extra cash flows and they pay out a dividend, stock owners can also profit by receiving a portion of that dividend. There’s no promise of payment made by the company that issues the stock, so the risk falls to the shareholder to determine whether or not the company will be a good investment.

Stock investing can be very uncertain. Therefore, individual stocks are usually considered the riskiest form of investing. After all, if you’re investing in one company, you’re essentially putting all your trust in that company’s ability to grow your investment and at the same time, risk losing it all if that one company has a poor outcome. Stock investing can also be very rewarding if you have the time and the inclination to work at it.

Bond – Buying a bond means you’re loaning a company money and they are promising to pay you interest and eventually return your initial principal. Bonds are typically less risky than stocks because the interest must be paid, or the bond goes into default. If a bond is in default, then bond holders have some rights to garnish company assets in order to be paid back. This is much unlike stocks where companies are not required to pay shareholders anything.

The rate of interest a bond pays depends on two things; credit worthiness of the bond issuer and its maturity date (the date the bond issuer promises to pay back your initial principal investment). Bond issuers with high credit ratings tend to pay lower rates of interest and those with low credit ratings pay higher rates of interest in order to attract investors to their bonds. Bonds that mature in a short period of time also tend to pay a lower rate of interest than a bond with a later maturity date because investors are taking on less risk by buying something that matures in a shorter amount of time.

Both of these investment types carry their own sets of advantages and disadvantages. These can depend on a myriad of things including an investor’s tolerance for risk, the market cycle, the financial strength of a company issuing the stock or bond, and even interest rates and inflation. Check out the table below for a summary of the key characteristics of each of these two types of investments.

Stay tuned this month for information about mutual funds, ETFs and the different types of available investment accounts.

- Margaret Gooley, CFP®, Worley Erhart-Graves Financial Advisors