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Cents and Sensibility Guy Steele |
Learning ‘basics’
of stocks and bonds
is good startIf you're fairly new at investing, you might find it to be somewhat confusing. What are the benefits of stocks and bonds? What are the risks? Is there a good reason to invest in both?
Once you know the answers to these questions, you'll have a good understanding of investment basics. And that knowledge can serve you well.
So, let's begin with stocks. What are they and why do people invest in them? Simply put, stocks represent ownership shares in a company. When you buy stock in Company ABC, you own a piece of it, however small. You'll receive ABC's annual report, and typically you are entitled to vote on some important company issues, such as whether to issue additional stock or replace ABC's board of directors.
People invest in stocks because they hope to profit by selling shares for more than what they paid. The stocks most likely to provide these profits are usually called "growth" stocks. But investors also purchase stocks for the "income" they can receive as dividends, which are paid from the company's profits. These stocks offer both the potential for growth and the opportunity to receive dividends and are typically called "growth and income" stocks.
When you buy stocks, you assume certain risks, such as the possible loss of principal. As a (very) general rule, the greater a stock's potential for growth, the greater the investment risk.
Now, let's switch from stocks to bonds. When you buy a bond, you don't own anything -- you're just making a loan. You can buy bonds issued by companies (corporate bonds), the government (Treasury bonds) or cities and states (municipal bonds). In each case, you are loaning out your money in exchange for regular interest payments and the return of the bond's face value when the bond matures.
Bonds, like stocks, carry risks. If you buy a corporate bond from a company that runs into problems, the company may default on your bond, and you won't get your principal back. Generally, you can help avoid this problem by investing in high-quality bonds. Municipalities can also get into trouble and default. U.S. government bonds, though, are considered to be the safest investment in the world, at least in regard to default potential.
When you invest in bonds, you'll also take on other risks. For one thing, if your bond matures at a time when rates have fallen, you may have to reinvest the proceeds in a bond that pays a lower interest rate.
On the other hand, when interest rates rise, the value of your existing bonds will fall. Let's look at the following example: With all things being equal, your bond pays 4 percent, and market rates rise to 6 percent, no one will want to pay you the full price for your bond. So, if you want to sell it, you'll have to offer it at a discount. By holding your bonds until maturity, though, you won't have to worry about price fluctuations.
Stocks and bonds clearly have some different benefits and different risks. And stocks and bonds frequently move in different directions. When the stock market is slumping, bonds sometimes perform well -- and vice versa. That's why you'll want to build a diversified portfolio by investing in a variety of stocks and bonds. By spreading your dollars this way, you can help cushion your portfolio from downturns that hit one type of asset particularly hard -- and you can give yourself more chances to succeed.
It's true that the investment world can get pretty complex. But it all starts with the basics: stocks and bonds. Try to become familiar with both of them -- it will be time well spent.
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Guy Steele is a financial planner and head of the Pali Palms office of Edward Jones. Send planning and investing questions to him at 970 N. Kalaheo Ave., Suite C-210, Kailua, Hawaii, 96734, or call 254-0688