The Basics of Stocks and Bonds

Stocks and bonds are two of the most common investment securities available. They, along with mutual funds, are generally considered to be staples of a well-diversified, solid investment portfolio. We will attempt in this article to focus on the basics of stocks and bonds. Let’s begin with a look at bonds.

A bond is actually an IOU, an acknowledgment by the issuer that money has been borrowed and is to be paid to the holder of the bond at a specified rate over a predetermined period of time. The price paid (or, the amount loaned) for a new bond is called the face value or principal; this amount is paid back at the end of the time period, also known as the maturity date.

The interest that the bond pays is called the bond yield; it’s expressed as a percentage of the bond’s face value. For example, a $5,000 bond with an eight-percent yield would pay $400 in interest per year. The interest can be paid out in yearly payments, or coupons; bonds that do not pay out yearly but instead pay the principal and all accumulated interest at maturity are known as zero-coupon bonds.

Federal governments, municipalities, and individual companies are all major bond issuers. Because bonds promise to pay back an investor’s principal plus a fixed rate of interest, they are generally considered to be less risky than stocks, which could either grow at unpredictable rates or lose value. However, bonds are not totally risk-free, because the issuer could default on the loan if it is not able to make the payment at maturity. Only bonds issued by the U.S. government avoid this risk.

A stock is a share of ownership, or equity, in a company. An investor who owns stock in a company is a part-owner of that company, along with all the other stockholders. As such, they have a claim on the company’s assets, as well as voting rights in company matters.

Unlike bonds, stocks do not guarantee a certain amount of return on investment; in fact, they guarantee no return at all. In other words, it’s possible to lose all or part of the investment. A stock’s return-on-investment (ROI) must therefore perform better in order to compensate for this greater risk to the investor’s money. Stock ROIs come in two forms: dividends and capital gains. Dividends are payouts to stockholders from company profits. Capital gains accrue when the value of the stock increases above its purchase price, thereby increasing the value of the investment.

Historically, stocks have outperformed bonds and all other investment vehicles over the long term. Since 1926, stocks have averaged a yearly rate of return of ten percent. No other investment has done this. While those returns are not guaranteed for the future, it’s generally concluded that investing in a wide range of stocks (called diversification) over a long period of time should give similar results since the market can be expected to continue to perform as it has in the past.

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