Your Money_ The Missing Manual - J. D. Roth [127]
Stocks and Bonds
Let's say your best friend Mary wants to open a pizza parlor, but she needs some money to do it. She comes to you with a business proposal that offers you two options. Here's the first:
For $10,000, you can own 10% of the restaurant. In return, she'll pay you a piece of the profits every 3 months. These dividends don't amount to much (maybe a few hundred bucks a year), but they'll give you a reliable stream of income. Plus, you can sell your share of the ownership (your stock) anytime.
If Mary's business is going gangbusters and makes good profits, you might be able to sell your stock to your friend Rhoda for $15,000 or even $20,000—much more than it cost you. But if your neighbor Phyllis opens another pizza parlor next door, it'll probably dent Mary's business. In that case, you might only be able to sell your stock for $8,000 or even $5,000.
When you buy stock, you're buying small slices of equity (ownership) in a business. As the company goes, so goes your investment: There's always the risk that the company will make a mistake, face stiff competition, or that the public's whims will change. When this happens, the value of the stock can drop permanently or the company can go out of business.
This sort of uncertainty might scare you. Sure, the constant stream of dividends would be nice, but you don't like the idea that the value of your investment will jump around all the time—or maybe even drop to zilch. In that case, Mary gives you another option:
If you lend Mary $10,000 for 5 years, she'll pay you 3% interest, or $300 a year. And at the end of the 5 years, she'll repay your $10,000 loan (or bond). What's more, you can sell this loan just like you could sell your stock. For example, if you decide you need the $10,000, you can sell the loan to your friend Rhoda, but she may not want to pay you the full $10,000.
Again, imagine Phyllis opens a pizza parlor next door to Mary's. She, too, is asking people to lend her money, but she's offering to pay 8% over 5 years. If Rhoda can buy an 8%, 5-year bond for $10,000, why would she pay you the same amount for a 3% bond? Instead, she might offer to buy it from you for $7,500. On the other hand, if Phyllis is only paying 1% interest on the loans she's taking, Rhoda might be willing to pay a little extra for your bond, since you're offering the best deal in town.
When you buy a bond, you're lending money to a business (or government). As with stocks, there's still a chance that the company will go out of business and you'll be left with nothing, but there are ways to reduce this risk. You could buy just the highest-rated bonds, for example, or only government bonds. (Government bonds are generally considered safer than corporate bonds, but there are exceptions.)
Note
Bonds are given grades—or ratings—based on how likely they are to be repaid. It's difficult for individual investors to buy bonds directly. For most folks, it's best to stick with bond mutual funds (Mutual Funds). To learn more about how bonds work, see http://tinyurl.com/GRS-bonds or read Chapter 7 of Personal Investing: The Missing Manual.
Though the prices of both stocks and bonds fluctuate based on economic and market conditions, stock prices are far more volatile: They offer the potential for greater returns—and greater losses. On the other hand, if you own a bond until it matures (that is, until the end of the time period you agreed to), you know what kind of return you'll get.
As you learned in the last section, stocks—as a group—tend to outperform bonds over long periods of time. The challenge is trying to pick which stocks will do well and which won't; even the pros get it wrong much of the time. It's not as easy as it sounds. If investors knew for sure which stock would perform best, they'd dump all their money into it. But they don't know