Whether you have some cash you want to directly invest or you are just trying to decide on the best plan for your retirement savings accounts, understanding how stocks and bonds work is critical. Although they seem intimidating, the concepts of stocks and bonds are actually quite simple for anyone to understand.
First, let’s start with stocks, which are what usually comes to mind when people think of investing. When a company wants to grow and needs capital, one technique it uses is going public and allowing individuals to buy shares of the company, represented by stock certificates. The shareholders take on partial ownership, with claim to a very small percentage of the company’s assets and earnings.
The confusing aspect of stocks is that their current prices are dependent on what people will pay for shares, not on how much the company has in physical assets or earnings. If people fear a company will perform poorly and start selling stocks, the price will decrease until demand rises again and individuals purchase stocks at that lower price. Therefore, stocks can be very volatile, increasing and decreasing in value throughout the day. However, in the long run, the stock market as a whole gains about 10 percent per year, making it a great long-term investment. This long-term gain is based primarily on actual earnings by the companies.
When investing in stocks, you can either select individual companies to include in your portfolio or buy an index, such as the S&P 500, to get a wide variety of stocks that will track market trends as a whole. The best strategy depends on whether you feel educated enough to select stocks on your own and how much you want to be paying attention to industry news and making decisions on when it is time to sell a stock.
Now, on to bonds. These are a way for a company to directly borrow from investors rather than selling shares of the company itself. When a company issues a bond, it promises to pay a percentage of interest to the bearer each year, in addition to buying the bond back for its face value after a specific number of years. Bonds are a bit of a gamble because the company could go under before the bond is bought back, but overall, they are less risky than stocks.
One of the interesting things about bonds is that their market price often varies from their face value. Depending on how well the company is doing and how many years are left until maturity, investors might offer to pay less than or more than the bond’s face value to buy a bond on the market.
Stocks and bonds are the two major types of long-term investments, along with mutual funds that are combinations of different stocks and bonds managed by a professional investor. Mutual funds are an easy way to invest without doing much legwork yourself. You can select funds with different balances of stocks and bonds to manage your risk and expected return based on your investing strategy.