The Basics of Stocks and Bonds.
When meeting with new clients to work through the process of taking inventory of what they own, my primary concern is in seeking their knowledge and understanding of what they own and why they own it. Clients often speak in general terms about how they were placed in a position that required a hasty decision to be made, based in part on terms that they generally didn’t understand at the time.
Understanding what you own can help tremendously in tempering your emotions during turbulent economic times. Why would any rational person make a deliberate decision only to end up with regret? This happens when we, as humans, allow our personal biases and emotions to drive our decisions.
Question. If I were to ask you to define the term “stock” and the term “bond” with only one single word for each term, how would you define the two terms? Give up? When you purchase stock in a company, you are an owner. Conversely, when you purchase a bond, you are a lender. Pretty simple! But you would be surprised how many people do not understand these simple definitions.
Now let’s talk about owning stock in a company by comparing it to your own personal life. If a person were to work forty years, buy a home, furnishings and cars while they save and pay off their debt, then their net worth will eventually increase over the forty years.
A company does the exact same thing. They provide a product or service, increase the demand by advertising, save their money, pay off debt, and work to increase the sales of their product or service. Over time, the company’s stock becomes more valuable. As a result, you should be able to sell the stock for a profit, known as a capital gain. However, the opposite is true as well. If an individual over spends and then loses their job, then they may have to file bankruptcy. The same concept holds true as well for a company.
The other side of a stock is a bond (loan). If you personally loaned your friend $1,000 at 6% interest and the loan was paid back over time, you would gradually receive the 6% interest. But if your friend decided you were no longer friends, he could default on the loan. Then you would be left with taking your former friend to court to obtain a judgement.
Bonds essentially work the same way, except you will be lending your money to a company (corporate bonds), a city, town, or school corporation (municipal bonds), or a government (government bonds). The main difference between my example of lending money to your friend and buying a bond is that a bond typically pays interest twice a year and comes with a stated maturity date.
By owing stocks and bonds, you will potentially receive two sources of return – interest payments and/or capital gains/losses. Your total return on investment is calculated by adding together the two sources of return. Hopefully, this has helped you to form a basic understanding of a stock and bond.
