If you’re new to personal finance or investing, two of the most commonly used terms are 1.) stocks and 2.) bonds.
Both stocks and bonds are beneficial ways for start-up companies to raise money or capital to fund their company’s growth. Both are important to know, and should be understood before pursuing any type of investment opportunities.
If you’re new to investing, I highly recommend subscribing to Investopedia’s term of the day newsletter. You’ll receive an email with their investing term of the day along with related articles. Compound this self-education over 365 days a year, and you’ll become a personal finance guru in no time!
So, what should you invest in……stocks………bonds……or both? And if both how much of each?
First, let’s go over the basics.
When companies decide to raise capital for future growth, they sell shares (public or private) of their company for money in the form of stocks. This is typical for businesses that need extra financing, and a much needed step for soon to be larger companies. Investors that purchase stock own a certain percentage of that company, depending on how much they invest. The more shares you own, the more ownership you have over that company.
So, are all stocks the same? No, not really. They can differ by how much money any particular company generates, their rated value, or recent growth.
- Value stocks: companies with solid fundamentals and are priced below their competition.
- Growth stocks: higher risk, but offer potentially quicker results compared to average stock.
- Large-cap stocks: market capitalization of $5 billion dollars or more.
- Mid-cap stocks: market capitalization of $1-5 billion dollars.
- Small-cap stocks: market capitalization of less than $1 billion.
When it comes to risk, lets first realize there’s risk everywhere in life, so don’t be afraid to invest. Compared to bonds, stocks will be riskier. It is 100% possible to lose all of your invested money with stock investments. If you invest in a company/companies stock and they file for bankruptcy, you are going to lose every single penny invested. On the other end, stocks typically offer much greater return on investment than bonds. A good, quality stock investment has the potential to be riskier in the short term, but offer extreme payouts in the long run.
Also, ownership of stock varies from individual companies, ETFs (exchange-traded funds), and mutual funds. I plan on extensively going over these in later blog posts so stay tuned.
If you’re an investing newbie, I recommend a low expense ratio index fund for first time investments. I advise beginner investors to avoid trading individual stocks because a.) statistically you’re likely to lose in the long run, b.) ETFs and index funds offer better returns over time, and c.) it can become very addicting, similar to gambling. If you do invest in any individual companies stocks, do you research and buy/hold your stock investments.
When you decide to invest in bonds, you have ZERO ownership of that/those company/companies. A bond is a loan agreement from an investor (yourself) to a company needing more money for growth and expansion. Once the debt to the investor is paid off, payments from that company ends.
Majority of bonds pay back 100% of the original full investment, meaning they are more reliable. Can your bonds lose you all your money similar to stocks? Yes, but it’s extremely rare and something an investor shouldn’t be too worried about when investing in bonds.
Also, bonds pay a fixed rate on interest, making your income stream predictable, and taking away some element of risk.
One of the biggest bond killers is inflation, and THE main reason why I invest a bare minimum in bonds. If you don’t know what inflation is, Google it. To show how inflation effects your bond’s return on investment (ROI), let’s take the following example:
- Bond bought in 2018 with a fixed return of 4% per year for 20 years.
- Let’s say the average inflation is 2% per year for the next few years.
- By 2020, you’re breaking even, not gaining any monetary value at all.
Similarly, interest rates offer a large risk to bonds. Rising interest rates lower the value of your invested bonds. This requires a very detailed explanation as to why this occurs, so I’ll also go over this in another post. But if you do decide to invest a large sum of money into bonds, I suggest you do some more research into bonds, inflation, and interest rates and how they affect each other before investing.
You probably wondered why this section was so short. Simply because I’m not a huge advocate of investing into bonds, especially at my younger age, so let me explain.
The Difference & How to Invest
If there’s one thing to remember from this post is that generally, bonds are less risky than stocks, but lack the high return on investments that stocks potentially offer. Bonds provide a safety net and stable income. Stocks have the possibility to generate larger gains and provide ownership of a company.
So, which to invest in?
Well then how much in each? It depends.
The amount to invest in stocks and bonds varies for many reasons, but the biggest factor is age. While you’re young, keep the majority of your assets (look this word up) in stocks and much less in bonds. If a slight market crash does occur, you’re young enough to recover and still come out on top, benefiting from of years of compounding. This, along with yearly inflation, is why I rarely invest in bonds or bond funds.
But, as you grow older, you should shift more of your investments into less risky bonds for safe keeping. If you’re looking to retire soon and have done a good job investing your entire life, no need to be extremely risky with the always changing stock market that you have no control over. Invest in bonds instead.
A general rule to follow is to subtract your age from 110 to determine your asset allocation. From this, a 25-year-old will have 85% of his/her investments in stocks and 15% in bonds.
I’m way more aggressive when it comes to investing. In my Roth IRA and brokerage accounts, I have 100% of my investments in stocks. And as far as my 401(K), it’s a 90/10 stocks to bond ratio.
Is this too aggressive for you? Quite possibly so. It’s something you’ll have to look into yourself to find out. Don’t just take what I say here has the holy grail of investing methodology. Research for a good 3-4 months, THEN make an educated investment decision, and learn from you and other’s experiences.
Hope you all enjoyed this week’s post! If you’ve missed last week’s post on “A Man and His Mustache”, click here. As always, don’t forget to like, comment, share, and subscribe!
“An investment in knowledge pays the best interest.”
Book of the Month: “The Autobiography of Malcolm X” as told to Alex Haley