Get the Skinny on Stocks and Bonds

Stocks¹
Most people know something about the stock market, but many investors who see stock as a way to get rich quick might not understand exactly what stock is and how it works. Before jumping feet-first into investing in stocks, it's important to understand some of the basics and the risks involved in owning stocks.

Stock is quite simply a share in the ownership of a company. When you buy stock, you're actually buying an equity piece of the company it represents. In other words, you have a claim on part of the corporation’s assets and earnings.

A company therefore can raise money by “going public” and selling a portion of the company by issuing stock. The advantage to the company is that it doesn’t have to pay back the money or pay interest right away, as it would to a bank if it borrowed the money it needed. The advantage to the shareholder is the potential to make money through dividends and/or capital appreciation.

As a partial owner of the company, you take on the potential risks and benefits of that position, but you don’t have to put any effort into running it. Your ownership is determined by the number of shares you own divided by the total number of shares sold by the company. If a company is profitable, it may decide to pay dividends to shareholders from its earnings. On the other hand, some companies may decide to reinvest profits back into their businesses rather than pay dividends.

Investors have the potential to make money from dividends as well as from appreciation in the value of stock shares on the open market. So stockholders have the potential to make money if the company does well and the potential to lose money if the company does poorly. The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.

Shareholders of common stock also often have voting rights on major issues at annual meetings, usually electing a board of directors. Each share represents one vote. In this way, shareholders have a say in the way the company is run. Owners of preferred stock usually don’t have voting rights but have a higher claim on the company’s assets and earnings than common stockholders do. If a company pays dividends, preferred stockholders receive theirs before common stockholders.

There's always a risk when investing in stocks. Generally, the greater the risk, the greater the potential reward. You should determine your risk tolerance and financial goals before deciding to invest in stock investments.

Bonds²
Most everyone believes that over the long-run, nothing beats the stock market. This being the case, why would anyone invest in bonds? Although they may seem to pale in comparison to equities in the long run, bonds have several traits that stocks simply can't match.

First, capital preservation. Unless an issuer goes bankrupt and defaults on payments, a bond will offer its holder a high certainty of consistent interest payments (if held to maturity), and its holder will usually be returned the amount he/she originally invested.

Secondly, bonds pay interest at set intervals of time, which can provide valuable income for retired couples, individuals, or those who need the cash flow. For instance, if someone owned $100,000 worth of bonds that paid 8% interest annually (that would be $8,000 yearly), a fraction of that interest would be sent to the bondholder either monthly or quarterly, giving them money to live on or invest elsewhere.

Bonds can also have large tax advantage for some people. When a government or municipality issues various types of bonds to raise money to build bridges, roads, etc., the interest that's earned is tax exempt. This can be especially advantageous for those who are retired or want to minimize their total tax liability.

¹Investing in securities involves risk, including possible loss of principal. No strategy can assure success or guarantee against loss in declining markets.

²Selling bonds prior to maturity may make the actual yield differ from their advertised yield and may involve a loss or gain. Bond values will decline as interest rates rise and are subject to availability and change in price.