The performance of the stock market is front page news, and even non-investors seem to know whether it’s up or down. However, many beginning investors or people who are just considering investing for the first time don’t really have any idea what stocks are. Bonds are even more mysterious, since the bond market doesn’t get nearly as much press. Beginners may not want to ask for clarification for fear of seeming ignorant. However, investing in something you don’t fully understand is never a good idea, and luckily, it’s not as complicated as you may think. Here’s a (hopefully) simple explanation.
Stocks are shares in a company or corporation. When a privately owned company wants to become publicly owned, that company issues stocks which represent tiny shares of ownership in that company. Those shares are then bought and sold on the stock exchange. When an investor buys stock, he or she is basically buying a tiny piece of whatever company issued that stock.
There are many ways for an investor to make money with stocks, but most investors only need to understand the following two. The basic idea behind the stock market is that companies will grow and gain value over time, so their stocks will too. Therefore, an investor who buys a share of Company X for $20 today expects that share to be worth a lot more someday in the future, at which point he or she will sell the share and take the profit. The risk is that Company X may not gain value over time, in which case the investor could lose money.
Additionally, some companies pay dividends to their stockholders, meaning they share their profits. The company will issue a dividend of $X per share, and pay each shareholder that amount multiplied by how many shares they own. Many investors favor stocks that pay dividends because they like receiving the dividend income even when the stock price is down.
Bonds are relatively simple as well – they’re just loans by another name. Bonds are issued by borrowers who agree to pay back the amount borrowed plus a certain amount of interest (also known as a coupon) by a certain date. When an investor buys a bond, he or she is lending money to the seller, and makes a profit on the interest.
Bonds can be short term (less than one year), medium term (one to ten years), or long term (more than ten years). Some bonds will pay interest one time per year, some will pay twice per year. There are many varieties of bonds (junk bonds, fixed rate, floating rate and more), but they all work in basically the same way. Bonds are generally considered safer than stocks, but they do carry some risk, which mostly depends on the financial stability of the issuer or borrower.
Understanding what stocks and bonds are and how they work is essential for beginning investors. Now that you have a basic understanding of stocks and bonds, you may want to find out about other investments, such as mutual funds. I’ll be posting an article called “What is a Mutual Fund?” very soon.