Understanding Stocks & Bonds: Risks, Rewards & Strategies
Financial security unlocks a brighter future for ourselves and those we love. Investing in stocks and bonds is a way to build wealth. It is available to anyone with some extra money. Even if owning a business or buying real estate seems difficult.
Owning stocks and bonds has been a time-tested strategy for building wealth, and with good reason. Data compiled by Vanguard shows that a 60/40 portfolio, consisting of 60% stocks and 40% bonds, generated an average annual return of 8.8% between 1926 and 2019. While that may not seem like a lot, the power of compounding interest is significant. An 8.8% annual return doubles your money roughly every nine years.
What are Stocks?
Think of stocks as tiny pieces of a company. When you buy stock in a company, you're essentially buying a small ownership stake in that company. The more shares you own, the bigger your ownership stake.
As the company performs well and grows, its stock price typically goes up. This means that the value of your ownership stake also increases. For example, imagine you buy 10 shares of a company's stock for $10 per share. If the company's stock price goes up to $20 per share, your 10 shares would now be worth $200!
Of course, the opposite can also happen. If the company struggles or its profits decline, the stock price could fall. In the same example, if the stock price fell to $5 per share, your 10 shares would only be worth $50.
When you buy stocks, you have the potential to benefit from a company's success. However, there is also the risk of losing money if the company performs poorly. It's important to do your research and understand the risks before you invest in any stock.
How do I make money from Stocks?
One respected way to make money with stocks is to buy it at fair prices. Another important aspect is keeping them for a long time. This strategy is called "buy and hold investing." It is considered a straightforward and accessible approach to participating in the stock market.
Stock prices can change a lot in the short term because of temporary economic conditions and market feelings. Stock prices can fluctuate in the short term due to temporary economic conditions and market sentiments. However, in the long term, the primary factor influencing a stock's value is the company's earnings per share. The more profitable a company becomes, generally the more valuable its stock.
This usually happens when the company is stable and makes more money than it needs for its own growth.
Investors can use options. Options are contracts that allow them to buy or sell a specific number of shares. They can do this at a set price and time.
The investors are not obligated to buy or sell the shares. They can be used to hedge other holdings, speculate on stock prices, or generate income.
Important to remember that all investments involve risk, and there is no guarantee of success. Before investing, it's important to do your research and understand your risk tolerance. Consult with a financial advisor.
Types of Stocks
In stocks, there are two main flavors: common and preferred. Each offers distinct ownership rights and benefits, catering to different investment goals.
Common stock is the most prevalent type. When you buy it, you become a part owner of the company. You get a share of its profits and can vote in shareholder decisions at annual meetings.
Some companies even have multiple classes of common stock, offering varying voting rights. For instance, Alphabet (GOOG and GOOGL) has two classes, with GOOG shareholders having voting power and GOOGL shareholders don’t.
Preferred stock functions more like a bond than common stock. A preferred stock has a set dividend, which is typically higher than the regular stock in the same company. Additionally, it has a fixed price for when the company buys back the shares on a specific date.
This provides stability and predictability, similar to bonds. However, unlike common stock, preferred stock typically doesn't grant voting rights and has limited potential for significant price appreciation.
Common stock has the potential to provide more money through dividends and price appreciation. However, it is also riskier due to the volatility of the market and the uncertainty of the company's success. Preferred stock provides steady income and lower volatility, but with limited upside potential and no voting rights.
Ultimately, the best type of stock for you depends on your individual investment goals and risk tolerance. If you prioritize income and stability, preferred stock might be a good fit. If you're comfortable with higher risk in exchange for the potential for bigger gains, common stock could be the way to go. Remember, diversification is key, so consider incorporating both types of stocks into your portfolio to balance risk and reward.
Pros and Cons of Stocks
Stocks have long been a popular way for individuals to build wealth, but they also come with inherent risks. Let's dive into the pros and cons of investing in stocks to help you make informed decisions:
Pros
Stocks can grow in value because they are connected to how well a company does, unlike savings accounts or bonds. If a company's earnings per share (EPS) steadily increase, the stock price can follow suit, offering investors substantial returns.
Accessibility: With the rise of online investing platforms, buying stocks is easier and more accessible than ever before. Even individuals with modest disposable income can start investing in stocks with fractional shares.
Proven Track Record: Over the long term, stocks have historically outperformed other asset classes like bonds and cash. Although past performance does not guarantee future results, historical trends indicate that stocks can help build wealth over time.
Cons
Risk of Loss: Unlike some investments with guaranteed returns, stocks come with the inherent risk of losing money. If a company does badly or goes bankrupt, its stock price could drop a lot, making investors lose their money.
Volatility: Stock prices can fluctuate significantly in the short term, driven by various factors like market sentiment, economic news, and individual company performance. This volatility can be emotionally challenging for some investors, especially those with short-term investment horizons.
Changes in the stock market can evoke strong emotions in people. These emotions can lead to hasty decisions driven by fear or greed. It's crucial to have a well-defined investment strategy and stick to it even during market downturns.
Remember, investing in stocks involves careful consideration of your risk tolerance, investment goals, and time horizon. By knowing the advantages and disadvantages and researching investments, you can make smart choices that match your financial objectives.
How do I buy Stocks?
It's easier to buy stocks now with online brokers. They offer cheap or free trades and different account options to fit your needs. Many brokers now offer commission-free trading, making it more affordable than ever to participate in the stock market. Additionally, fractional investing allows you to invest any amount of money in a stock, even if it's not enough to purchase a full share.
Before you start investing, it's important to do your research and understand the risks involved. The stock market can be volatile, and you could lose money on your investments. It's also important to choose a broker that is reputable and regulated.
What are Bonds?
Bonds are essentially loans you make to a company or government. You provide them with capital upfront, in exchange for a fixed interest rate paid at regular intervals. At the maturity date, you receive the face value of the loan back, similar to repaying a debt.
Because bonds represent a loan with defined terms, they generally exhibit lower volatility compared to stocks. The fixed interest payments provide a predictable income stream, making them suitable for investors seeking stability and regular income.
However, it's important to remember that no investment is entirely risk-free. If the borrower experiences financial difficulties and defaults on the loan, bondholders may lose some or all of their principal investment. The extent of the loss depends on the borrower's creditworthiness and the terms of the bond.
How do I make money with bonds?
Investing in bonds is often seen as a safe and reliable way to earn a steady income. Think of it like lending money to a company or government, who promises to pay you back with interest. This interest, called the yield, is your reward for providing the loan.
But here's the catch: bond prices are like seesaws, going up and down depending on interest rates. When interest rates rise, existing bonds become less attractive, and their prices decrease. Conversely, when interest rates decrease, existing bonds become more valuable, and their prices increase.
However, there's a secret weapon bondholders possess: maturity. If you buy a bond at or below its face value (the amount you'll receive at maturity) and hold it until it matures, you'll earn the promised yield plus receive your original investment. That's like getting paid interest and having your loan repaid in full!
So, while bond prices may fluctuate, holding them until maturity provides a safety net against price swings. It's like having a guaranteed income stream, even if the market gets bumpy.
Remember, bonds are generally less volatile than stocks, but they also offer lower potential returns. It's all about finding the right balance between risk and reward that fits your investment goals.
Types of Bonds
Investing in bonds can be a wise choice for those seeking steady income and lower volatility than stocks. But just like any investment, there are different options with varying risks and rewards. Here's a breakdown of some key types to consider:
Treasury Bonds: Think of Treasury bonds, notes, and bills as loans to Uncle Sam himself. The U.S. government issues safe bonds. These bonds can be short-term or long-term. Their maturities range from weeks to 30 years. While the yields are typically lower than other options, the security is unparalleled.
Municipal Bonds: Craving a bit more excitement than government bonds? Municipal bonds, issued by state and local governments, offer generally high safety with the potential for slightly higher yields. Think of it as supporting your community while earning a return. However, remember that the creditworthiness of individual municipalities can vary, so research is crucial.
Private companies issue corporate bonds, which have different levels of risk and reward for investors to choose from. Think of it like lending directly to a company. The more financially sound and reputable the company, the safer the bond, but the lower the yield. Conversely, riskier companies offer higher yields but carry the potential for greater losses.
This is just a starting point. Each type of bond has further subcategories and nuances to explore. Always research thoroughly and consult with a financial advisor before making any investment decisions.
Pros and Cons of Bonds
Pros
Bonds give steady income through regular interest payments, unlike stocks that can be unpredictable and unstable.
Lower Risk: Compared to stocks, bonds generally experience less dramatic price fluctuations, making them a more conservative investment choice. This translates to a lower risk of experiencing permanent losses.
Bonds can safeguard your investment's value from inflation as they usually have higher interest rates than inflation. Even though the bond price might move slightly, the regular interest payments can help offset inflationary effects.
Investing in bonds is like lending money to a company or government. They promise to repay you regularly with interest. While you might not get rich quick, it's a reliable way to generate income and preserve your capital.
How do I buy bonds?
Similar to buying stocks, many online brokers offer platforms for trading corporate and municipal bonds. You can buy new bonds from companies or existing bonds from other investors on secondary markets. Additionally, the U.S. Treasury Department's "TreasuryDirect" website lets you purchase government bonds directly.
However, for many investors, buying individual bonds might seem overwhelming. Here's where bond funds come in. Investment pools collect money from multiple investors and buy different types of bonds, similar to mutual funds. Diversification spreads risk and reduces volatility, making it popular for those who want a less involved strategy.
There are two main types of bond funds:
Bond ETFs (Exchange-Traded Funds): These trade throughout the day like stocks, offering flexibility and transparency. You can choose ETFs that specialize in specific types of bonds, like corporate bonds, high-yield bonds, or international bonds.
Bond Mutual Funds: These are professionally managed and traded once a day at the end of the trading session. Not as flexible as ETFs, but they have a fund manager who selects and manages the bond portfolio.
Before investing, research and understand the risks and rewards of different bond types and funds, regardless of the path you choose.
Bottom Line
Financial security isn't just a dream, it's a foundation for a brighter future for you and your loved ones. Owning stocks and bonds, though not without their risks, offers a time-tested path to building wealth, even for those starting with modest means. It's like building a sturdy house, brick by brick. Each investment, carefully chosen and managed, contributes to a more stable and prosperous future.
Remember, the journey to financial security is a marathon, not a sprint. Be patient, stay informed, and diversify your investments to weather market fluctuations. By being dedicated and disciplined, you can use stocks and bonds to reach your financial goals and create a better future.
Sources:
https://www.fool.com/investing/how-to-invest/bonds/bonds-vs-stocks/
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Options The strategy discussed above is for illustrative and educational purposes only and should not be construed as an endorsement, recommendation or solicitation to buy or sell any particular security. Options involve risk and are not suitable for all investors. Certain complex options strategies carry additional risk. Please read the options disclosure document titles Characteristics and Risks of Standardized Options by clicking on this hyperlink text https://www.theocc.com/about/publications/character-risks.jsp before considering any options transactions.