Stocks, Bonds & Mutual Funds

Every financial plan needs fuel to achieve its long-term goals. That fuel is commonly referred to as investments but knowing the type of investments you need can be crucial to reaching your financial goals.

Stocks

A stock is a certificate of ownership in a corporation. You are officially a super tiny minority shareholder if you have stock. You can own a lot of stocks or just one or even a fraction of one.

But if you bought a stock, what do you actually own? Unfortunately, as a stockholder you do not get a desk at the office or custom company business cards. While this might seem obvious, it is an important piece. Corporate stock ownership protects the company and you from significant liability. As an example, if the company behind the stock goes bankrupt, the bank does not hold you responsible for the debt. And vice-versa, if a major shareholder personally goes bankrupt, the banks could not seize the assets of the corporation to pay the debt.

It is important to note that there is no protection for the value of the stock – if that same company goes bankrupt, the value of your stock may go to zero. With a stock, what you do actually own is access to dividends or profits that are paid out, voting rights, and the right to sell your share to someone else.

A key value of a stock is dividends. Each year, companies make profits, and the board of directors decides what to do with those profits. Usually, they pay out a portion and use a portion to reinvest in the business.

Depending on your specific financial goals, it is important to know if you are buying stock that has a high priority on growth and will prioritize reinvestment, or a company that focuses on stability and will prioritize paying larger dividends. Depending on your situation, both can be a benefit to your portfolio and long-term goals.

Bonds

A bond is simply ownership of debt. When you purchase a bond, you are buying a contract. If you were to purchase a bond today, you would typically need to understand five key terms.

1. Face value – nearly all bonds have a face value of $1,000, this is the amount the bond is worth at maturity
2. Maturity – the date when the bonds face value will be paid to the owner
3. Price – price to purchase the bond, typically quoted as a percentage of the face value
4. Coupon rate – the payment you will receive each year on the bond (interest rate)
5. Yield – the yearly rate of return your money earns over the whole life of the investment

Bonds are typically issued by three entities, the federal government, companies, and local governments. US government bonds, also called treasury notes, are considered the safest form of debt because it is backed by the US government. Corporate bonds are rated in quality depending on how confident the issuer is that the borrower will be able to pay its obligation. Lower rated bonds typically have higher returns but also face the possibility of default. Local or state governments can also issue bonds, called municipal bonds, these are lower risk bonds and can have a strong tax advantage as they are usually exempt from federal income tax.

Bonds can be a great fit in a portfolio to reduce risk. Usually, when the stock market goes down, bond prices go up. As investors look to weather high market volatility, they choose bonds to provide stable and predictable returns.

Mutual Funds

If you go to a horse track and bet $100 on 5 races, attempting to pick the winner of each race, you have an opportunity to win big, but at huge risk to go home with nothing. This is like buying a single company’s stock in the market.

In comparison, when you invest with a mutual fund manager you are counting on their expertise. The mutual fund may allocate that $500 to several different horses and types of bets over the same 5 races. This strategy generally reduces your risk but may also reduce your returns. Also, it’s important to note that you generally must buy the mutual fund lunch and pay for their tickets into the race. That is to say, mutual funds charge fees to help execute their strategy.

Mutual funds are a specific combination of both bonds and stocks. A mutual fund is a manager or group of managers that outlines a specific strategy of buying and selling bonds and stocks. The manager creates a document that outlines that strategy called a prospectus. Mutual funds vary in cost and in complexity. Mutual funds are the easiest solution to help investors create easy diversification across different stocks and bonds.

It can be helpful to know about a few types of mutual funds:

• Bond Funds – focus on strategies related to buying and trading different bonds
• Index Funds – trade specific securities related to a market index; these funds generally have the lowest fees since they are not trying to beat the market and are simply mirroring it
• Income Funds – Funds that buy certain stocks and bonds with the primary goal being income generation, not just increase share value
• International Funds – funds that invest overseas can be great due to most investors lack of knowledge in foreign markets

Key Takeaway

Investing is a key strategy in achieving your long-term financial goals. There are several ways to reach your financial goals but choosing the type of fuel is a key indicator in how fast you reach it and with how much risk along the way.

Disclaimer: This post is for informational purposes only and is never to be taken as advice or a recommendation. Talk to a tax or legal professional to determine how this information best applies to your personal situation.