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Investing 101: What’s The Difference Between Stocks and Bonds?

Let’s face it, few topics are more confusing than investing. Unless you’re a finance major, you didn’t have a class in school that taught you about the stock market. The financial sector is full of obfuscation too and even knowledgeable investors need diligence. “Experts” often make things seem more complicated than they are. They’ll say you can’t invest alone, you need their services and products. A fiduciary is a nice luxury for some people, but it’s unrealistic for those struggling with student debt.

We know that saving for retirement is crucial. Even if you aren’t in a position to save right now, you’ll want to learn the basics of financial products. Before putting money into a 401k, you need to know what to buy with it. Almost everything you can put into a retirement account is some variation of a stock or a bond. Stocks and bonds are the vehicles businesses use to raise money for new ventures. And if the company is publicly-traded, anyone can buy these assets.


How Companies Fund Themselves with Financial Assets

Let’s say that Elon Musk wants to raise $10 million to invest in a new marketing campaign for Tesla (something he may need). Ten million is a lot to ask from a bank, so he needs to find another source. As a publicly-traded company, Tesla could issue shares of stock, letting investors buy little pieces of the company. Or they could issue bonds and sell them with the promise of returning the money later with interest

Bonds and stocks are the two main vehicles driving the expansion of these companies, but they function in very different ways. There’s a simple way to differentiate though: think of bonds as loans and stocks as property.


How Bonds Work

Did your grandparents get you a savings bond when you were little? If so, you’ve been bond market participant longer than you realize! Bonds are issued by corporations and governments in order to raise funds. When someone buys a bond, the company or government entity selling it is now indebted to the bondholder. If Tesla sells a $10,000 bond with a five-year maturity (or term), that means the bondholder will get their $10,000 back in five years, provided Tesla doesn’t go bankrupt.

So what’s in it for the bondholder? A little extra compensation. The bond-issuing company will deliver a coupon (aka an interest payment) for a certain percentage of the bond’s value each year. If your $10,000 Tesla bond has a 6% coupon, you’ll get $600 in annual interest payments for five years AND your principal back after term expires. Bonds are called “fixed-income securities” because the rate of return is constant; you get the coupon payments and then you get the principal back.


Bond Ratings

Not all bonds are created equal. Bonds are rated by credit agencies (ie. Moody’s) based on their likelihood of paying out. Yes, if you buy a bond from Tesla and they go under, you’re losing your investment. The top bonds have AAA ratings, while the riskiest are rated CCC and below. Government bonds, called treasuries, have an AAA rating since the federal government has never defaulted on its debts (and probably never will, despite what your crazy uncle might say.)  But since they’re the safest bonds on the market, the coupon rates are lowest. The U.S. Treasury sells bonds with terms as short as a few months to as long as 30 years.

Municipal bonds are local and state-issued assets that have higher rates of default, but are still relatively safe and you’ll get a higher coupon rate for taking on the risk. And finally, we have corporate bonds, which could be safe depending on the company you buy them from. Microsoft, Johnson & Johnson, and Exxon-Mobil all have AAA rated bonds, but Tesla was recently dropped to BBB by Moody’s. It’s important to note that poorly-rated bonds will have a higher coupon rates since investors need to be compensated for taking on more risk.


How Stocks Work

When I mentioned above to think of stocks as property, I wasn’t making an analogy. Buying stock means buying property – a small stake in a company. When a company sells stock, what they’re really selling are tiny pieces of ownership. You buy 100 shares of Microsoft, you get 100 little pieces of Microsoft. You also get 100 opportunities to profit off Microsoft’s success.

How is a stock priced? When a private company decides to go public, they are evaluated by analysts who then underwrite what’s called an Initial Public Offering (IPO). The analysts evaluate the company’s financial health and potential future success and come up with a price for their shares. The shares are then sold to the public and traded on the stock market. If there’s more buyers than sellers, the stock price will rise. And if more sellers, down it goes. If the company is very successful, buyers will flock to the stock AND the company may return some profits to shareholders in the form of dividends.

Stocks can be risky. The market is subject to wild short-term gyrations and stocks can lose value in a hurry. Take MoviePass, the company that offers a subscription service for movie theaters. The MoviePass business model isn’t sustainable and investors have bailed, sending the stock crashing to 3 cents. If you put $10,000 into MoviePass in October 2017, you’d have less than 10 cents left today. But on the other hand, stocks can be a path to riches if you buy shares of great companies. In June 2015, Amazon traded below $300. Today, Amazon trades at $1880, meaning a $10,000 investment made in mid-2015 would be worth over $62,000 today.


Putting It All Together

When planning for retirement, you’ll be buying products like mutual funds and ETFs to build your portfolio, but these are just baskets different stocks and/or bonds put together. College grads dealing with student loan debt may think they’re at a disadvantage when it comes to saving, but they actually have the best ally on their side: time.

Compound interest is an amazing force. With a 7% rate of return, you can double an investment in a decade. If you start saving at age 25, that’s four decades of compounding before you hit retirement age. Stay the course during the wild swings! The S&P 500 returned 1.4% in 2015 and then leaped 11.9% in 2016. Save the same amount each month and pay no attention to short term market moves.

Beating the market is nearly impossible. Even the most sophisticated investors with high-tech tools and gadgets can’t beat the index funds that track the market as a whole. And if they can’t do it, you probably can’t either. The best plan is usually the most simple – buy low-cost index funds, stay invested throughout the ups and downs, and keep saving as much as you can.

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