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Stocks vs. Bonds vs. Mutual Funds

Stocks vs. Bonds

When you hear the term “stock” think “ownership”. Let’s say you’re considering whether to buy a stock or a bond in a hypothetical company, the “ABC Company”. If you buy stock in ABC Company, even one share of stock, you are actually part owner of the ABC Company. As an owner, however the ABC Company goes, so goes your stock investment. If ABC Company’s profits are up 20 or 25%, you may find your stock value up 20 or 25%. Conversely, if ABC Company’s profits are down 20 or 25%, you may find your stock value down 20 or 25%. It’s really no different than if you were to open up a store in the mall down the street, however the business does, that’s how your investment performs…just on a much bigger scale.

When you hear the term “bond” think “loan”. If you were to buy a bond from ABC Company, you’re actually loaning money to the ABC Company. Like any loan, the bond has an interest rate and a term (period of time for the ABC Company to pay your principal back). For the sake of our example, let’s say the interest rate on the bond you purchases is 5% and the term of the bond is 10 years. So in our example ABC Company will pay you 5% interest per year for 10 years. At the end of 10 years, ABC Company will pay your principal back. As a bondholder, if ABC Company’s profits are up 20 or 25%, well the company only owes you the 5% interest payment. However, if ABC Company’s profits are down 20 or 25%, the company still owes you the 5% interest on the bond.

Stocks and bonds are just two different ways for companies to raise money. A company can either sell ownership (stock) or take on loans (bonds). The key difference lies in the volatility characteristics of each. As you can see from our example above, there’s more potential upside in owning stock. But there’s generally much less downside volatility in bonds. Over time, the greater volatility associated with stock investments should provide greater long-term returns. Bond investments however, play a key role in a portfolio by reducing the short-term downside volatility associated with stocks.

What is a Mutual Fund?

Let’s say you have $1000 to invest, and you’re considering buying stock in the ABC Company. For the sake of our example, ABC company stock is trading at $150 per share. After factoring in trading costs it’s likely you are investment in ABC Company stock would be limited to only six shares of stock. That’s hardly a well-diversified portfolio. More importantly, your investment return is based solely on the performance of ABC Company stock. If ABC company stock were to suffer a significant decline in value, your entire investment would experience the significant decline. Worse, if ABC Company were to declare bankruptcy, it’s quite possible that you may lose your entire $1000 investment.

A mutual fund takes your $1000 investment along with lots of other people’s investments and pools it together so the mutual fund has millions of dollars, or even billions of dollars to invest. With this large pool of money the mutual fund is able to buy stock in ABC Company along with the stock of many other companies. By spreading your $1000 investment over many different companies, your downside risk may be reduced as your investment is no longer solely reliant on the performance of one company. More importantly, if ABC Company were to declare bankruptcy, you would not experience the complete loss of your investment as ABC Company stock is only one of many stock holdings inside of the mutual fund. In addition to potentially reduced downside risk, mutual funds can provide access to professional investment management, reduced trading costs, and may provide access to investments that are difficult for US investors to invest in directly such as emerging markets.