Stocks and Bonds, What's the Difference?
The Language of Money
When I first became aware of the idea to invest in stocks and bonds, the language was as far away from my understanding as is rocket science. I wondered often, "What exactly are stocks and bonds?" I tried watching the stock market programs on TV and even looked up the stock market online. They looked really cool, all of those sharp up and down line-graphs, pie charts, and scrolling numbers. Even the money jargon the financial wizards spoke had my attention. But, I still really had no idea what those colorful lines, graphs, and terms were trying to tell me. It was almost as if it was all designed to intentionally cause confusion. Not being much of a quitter, I stuck with it and in no time at all the world of money, stocks and bonds became my second language.
The first thing I needed to understand was "stock and bond" and in layman's terms. My long awaited need to find out, "What exactly are stocks and bonds?" would finally be answered while watching one of those money market programs. To my long awaited relief the nice financial wizard who was hosting the program simplified the term stock and bond for all who had tuned in on that day.
It goes something like this:
WHAT EXACTLY ARE STOCKS AND BONDS?
Not this kind of Stock...
What Is a Stock?
A stock represents part ownership in a company. Everyone who owns a stock is called a stockholder or shareholder. If a company has a need to raise capitol (money) usually to grow the company (expand business), it can do a few practical things: The company can borrow the money from a bank, it can issue (or sell) stocks to the public (you and me), or it can sell bonds (borrow money).
The company has to document the transaction when someone purchases a stock, so they issue stock certificates to the shareholders. This document (piece of fancy paper) describes the number of shares purchased at any one time by that person. If you buy more shares later, you will be issued another stock certificate.
If the company you are a shareholder with makes profits, you can make money in two ways:
- Making money through dividends
A dividend is an occasional payment (usually cash payment) made with the company earnings to it's shareholders. It depends on how the company profits are going, but most dividends are paid four times annually. The company's board can modify how often payments are made, (being more or less than quarterly) or even discontinue payments if their earnings falter. These are considered income stocks.
Some company's never pay dividends. As mentioned before, the company's that do are known as income stocks, and that is why investors tend to buy these, for regular cash income. (Utility stocks are also known as income stocks)
- Making money through Growth Stocks
Growth stocks are non-dividend stocks. This means they pay no dividends (no regular cash payment to shareholders), or if they do pay them, it is a very small cash amount. With this type of stock the company reinvests profits back into the company rather than paying the stockholder dividends. Investors buy growth stocks in anticipation of the value of the stock price increasing over time. Growth stocks are more risky than income stocks, but they offer far greater money making potential in the long term. Think about all of those investors who bought growth stocks in Apple or IBM, they most likely recovered more in growth value than the dividends could have ever managed.
WHAT EXACTLY ARE STOCKS AND BONDS?
A Savings Bond is a Fancy Piece of Paper?
What Are Savings Bonds?
As I continued to scratch around in the financial stock yard, I often heard the term U.S. Savings Bonds and bonds in general. I had learned that companies who needed to raise capitol could sell bonds to raise money, yet the actual definitive understanding still escaped me. So, a new quest fell in place as I set out to get the answer to my new question, "What are U.S. savings bonds?" or bonds of any kind.
I arrived at the library in my town mid morning and immediately went to the section where all of financial information in the world must reside. Within the pages of many books I found just what I was looking for, the answer to my bond question!
Simple as simple can be, a bond (unlike a stock) is an IOU. When you buy a bond, you are in effect loaning your money to the company or government agency who is selling the bond. Bonds are packaged in three types:
- Bonds issued by the U.S. government and/or its agencies.
- Bonds issued by corporations.
- Bonds issued by states, towns, or municipalities (These are known as tax-exempt and "munis").
Those who issue the bonds are obligated to pay back the full purchase price at a designated time, and not a minute before. This date is referred to as the "maturity date." Bonds fall into two types of time-related categories:
- Intermediate notes, these mature or become due in 2 to 10 years.
- Long-term bonds, which mature or are due in 10 years or more.
Until your bond matures, you receive a fixed (does not go up or down) rate of interest on the money you loaned in the bond. This interest is called the "coupon rate," which is generally paid out two times annually. To give you an idea what this means; if you have a bond for $1,000 that has an interest rate of 8%, you should receive a check for $40 every six months until the bond matures.
FOR THE TRIVIA BUFFS IN THE HOUSE:
The word "Coupon" goes back to a time when every bond was issued with a page of coupons attached to it. On each date specified on the coupon page, the bond owner would cut off that days coupon and take it to the bank exchanging it for real cash.
Example of how a bond would work (an EE US savings bond)
You buy an EE savings bond at any bank, there are no fees. The purchase price is actually 50% of the face value (a $50 bond will only cost you $25). You hold the EE bond until its maturity (coupon date), redeeming the bond at the bank. You are going to get paid $25 for the cost of the bond at the time of purchase, as well as the interest which would be $25. This one-lump cash amount at maturity will equal the $50 face value of the bond.
NOTE: Bonds stop earning interest on the maturity date (coupon date). This is when you should get them redeemed for the face value, or rolled over if allowed.
Stocks and Bonds for Beginners (1 min. 45 sec. video)
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