What are Stocks, Bonds, and Mutual Funds?
Stocks, bonds, and mutual funds are well known and powerful components of a diversified portfolio. To achieve desired returns to accomplish goals, it is extremely important to make sure there are different types of investments in a portfolio.
- When an investor buys a stock, part ownership in the form of a share is bought.
- Bonds are a type of investment designed to aid governments and corporations to raise money.
- In a mutual fund, money collected from various investors is taken together to buy a large variety of securities.
What is a Stock?
When an investor buys a stock, part ownership in the form of a share is bought. If the business or enterprise happens to do well, the investor benefits by seeing an increase in the value of the share. The share can either be held or sold at a profit on the stock exchange. If the business does poorly, the value of the share declines, and the investor may lose some or all of the investment.
Stocks are usually riskier than bonds as there is no guarantee that the stock will do well. However, there is potential to earn higher returns when it comes to stock trading. Companies sell their stock for various reasons, such as developing new products, expanding into new markets, or even paying off debt. The first time a company sells stock is called an initial public offering (IPO).
What is a Bond?
Bonds are a type of investment designed to aid governments and corporations to raise money. It can be viewed as a type of loan. There is no stock ownership and dividends, but investors who purchase bonds do receive payment in the form of interest.
For example, Company A needs to raise $2 million for a certain project. It decides to offer a 3-year bond to investors to raise the money. The investor will then purchase the bond at the issue price, and Company A will pay the investor interest on the money paid for the bond. Once the bond matures, the company will pay the face value of the bond back to the investor.
Therefore, bonds are fixed-income assets, unlike stocks. The percentage of interest is fixed in advance. Bonds are rated by credit rating agencies such as Moody’s and Standard and Poor to help investors.
There are broadly two types of bonds, government bonds and corporate bonds. When the government is in need of money, they can only issue bonds. Businesses issue bonds instead of seeking a loan or overdraft from the bank as interest rates are cheaper on bonds and the bond market offers better terms.
Stock vs. Bonds
When bonds and stocks are compared, bonds are considered to be a safer investment. It is important to note that bonds are not completely risk-free and only receive preference in case of bankruptcy.
Owning a stock offers more potential for returns, but bonds come with much less downside volatility. Bond investments play a key role in balancing and reducing the short-term volatility associated with stocks.
Stocks and bonds are characterized by asset classes. On the other hand, mutual funds are pooled investment vehicles. In a mutual fund, money collected from various investors is taken together to buy a large variety of securities. A mutual fund gives an investor instant diversification.
Mutual funds are not the same as stocks. When you invest in a mutual fund, you do not own shares of the stock invested in but own a piece of the fund. Furthermore, mutual funds are usually managed by fund managers in financial corporations. Once an investor purchases a fund, there is no control over what goes in or out of the fund. Therefore, there is no investment in a particular stock or bond but a combination of various assets. There is also a fee or commission to be paid.
Investors do not decide between stocks and bonds but decide on the proportion of the two in their portfolio. As stocks and bonds come with their own pros and cons, an investor will decide on the proportion according to the desired goals and risk tolerance.
Once decided, the investor then decides on which vehicle to use to implement such asset allocation choices. The investment vehicle can be mutual funds, exchange-traded funds, or individual securities.
There is no single investment channel that is best for any investor. Investments are usually based on four criteria, namely age, income generation, length of time until the money is required, and risk tolerance.
CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
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