Stocks and Bonds; A Primer

Entering the world of investing can be both exciting and overwhelming, especially when you consider the various investment opportunities. The investment world is dominated by two specific investment products; stocks and bonds. Although both are considered investments, the structure of these two products could not be more different.

Stocks represent ownership rights to publicly traded companies. For example, you can purchase shares of companies such as Apple and Microsoft in the open market because they are publicly traded. Privately held businesses such as Chick-Fil-A and Publix do not have stocks that you can purchase in the open market as they are private businesses. Stocks give investors the opportunity to reap the benefits of successful business as they grow. Some stocks pay out dividends which are cash flows generated from the business which are given back to shareholders although many stocks choose not to do this for a variety of reasons. Stocks can be more volatile than bonds but often offer investors higher potential returns to offset the risk in owning shares of a company.

Bonds are a form of debt issued not only by companies, but also governments. Investors essentially provide a loan to the business or government for a set period of time in exchange for periodic payments made back to the debt holder until the “maturity debt” where the original payment amount is given back to the lender or debt holder. Bonds are often seen as less risky than stocks, but will typically have a lower return profile than stocks.

To eliminate the financial jargon and to simplify let’s use alcohol to describe the differences between the two. Stocks are similar to beer. There are a variety of different beers with a wide array of concentrations. Some beers which have a higher alcohol concentration can get you tipsy but also may have a stronger hangover effect, which is similar to the risk/reward ratio of some stocks. Wine is like a bond. Who makes the wine is important as is who issues the bond. Further, the vintage date is relevant for wine as is the maturity date of bonds.

Although both instruments are very common, stocks and bonds serve different purposes. A mix of both is typically found in investment portfolios. Some investors who are closer to retirement and have a shorter investment horizon will often favor bonds due to their lower amounts of volatility and pre-determined payments while investors who have a longer investment horizon will often prefer stocks due to their higher growth profile which will typically carry more risk than bonds. A helpful tip for determining what percentage of your portfolio should be stocks and bonds is to use a simple mathematical formula:

(120 – investor’s age) = weighting of portfolio for stocks

Example: Using our formula above, an investor who is 40 years old would use an equity weight of 80% with the remainder being allocated to bonds resulting in an 80/20 split.

Both stocks and bonds serve their respective purposes and it is up to the investor to determine which options and mix serve them best.