What’s the first thing that comes to mind when you think about investing? Is it a mass of people, dressed in designer suits, yelling “BUY!”, “SELL!”, while holding several phones to their ears?
Despite the Wall Street image of the stock market, investing as a means to earn and save money is becoming more and more popular. Not everyone knows how to handle it though, or even where to begin!
As you probably already know, there are quite a number of ways to invest. But before jumping head first, it’s always smart to start with some investing basics: comparing stocks, bonds and mutual funds.
comparing stocks, bonds and mutual funds
Stocks are paper assets with potential cash value. When you buy stocks, you basically buy a tiny part of a company.
Companies who allow you to purchase stocks are literally selling part of the company to ‘strangers’. They use the money to further develop their business and share their success with share holders.
You can either earn money in form of dividends or get cash value, if you sell the stocks that have increased in value since you bought them.
Of course, this is the best case scenario.
Investing in stocks also comes with risks.
Here’s a harsh truth: buying stocks doesn’t guarantee any returns.
When you buy shares, you literally share the ups and downs of the company you invested your money in.
If the stock prices go down in flames, you might be tempted to sell. And many beginners opt for selling their shares because they fear losing even more money.
However, by holding on to your stocks even when things don’t look so bright, the stock prices might bounce back and you could recuperate your money or even make a small fortune.
Buying stocks comes with risks, but it can also come with a great return of investment! You may grow your net worth by investing in stocks, or you might lose all your money in the process.
Before you start dreaming about how you’ll get filthy rich by investing in stocks, start small to see how things work (you can buy stocks for as low as $10).
Since the stock market doesn’t offer any guarantees, do your research before dipping your toe into such investments.
Bonds are loans. Now let’s elaborate..
When you buy bonds, you’re literally loaning money either to an individual company, a corporation, a government entity or even a municipality.
In exchange, you get periodic interest payments, plus your money back when the loan matures.
Compared to stocks, the success or failures of a company shouldn’t affect your return of investment. You’ll receive regular payments in the form of interest, as opposed to irregular income generated by dividends.
Business or government entities need access to funds for a variety of reasons.
While some choose to sell shares of their own company, others prefer to ‘raise money’ to fund their projects by issuing bonds.
When a company or say, a municipality has a project in place, but not enough money to finish it, they start looking into options to borrow money. Since bank loans are expensive, issuing bonds seems like the perfect alternative.
Depending on the reasons these entities need money for, bond maturities can range from short term bonds (about 5 years or so) to long term (30 years).
Although they seem like a safe way to invest, bonds also come with risks.
For instance, the longer it takes for a bond to mature, the more difficult it is to predict how the market will fluctuate.
Maybe rates will increase significantly, but you’ll be stuck with an investment generating profit way below market value! Or, worst case scenario, companies go bankrupt and you lose your money.
Typically, the higher the bond yield, the riskier the investment. It makes sense to offer a higher payout if higher risks are involved. Which is why, before investing in bonds, do your homework and take these risks into consideration.
Related article: Alternative ways to save for retirement without a 401(k)
Mutual funds represent money pooled together by different investors, in order to make bigger and more diversified investments.
Mutual funds allow investors to invest in both stocks and bonds, and add other investment vehicles to the ‘mix’ as well, to further diversify their investment portfolio.
This type of investment also implies a reduced risk factor, since you have diversification on your side.
Not only that, but some mutual funds involve a manager who makes investment decisions based on the collective’s main goals.
This is a great advantage, since you don’t have to worry about what stocks to buy or conduct research on various companies. It’s the manager’s job to know all this.
With that being said, investors earn money in the form of dividends, interest and capital gains. All earnings are subject to tax, except for those you use to top off your retirement funds.
Mutual funds sounds like the perfect way to invest, but of course you know what comes next… There’s a downside to investing in mutual funds as well.
You can add money to your retirement savings without paying taxes, you have the collective’s manager to worry about where it’s best to invest, so what’s the catch?
While having a diversified portfolio sounds great, investing in mutual funds can turn out to be very expensive.
Management costs and in some cases, other additional fees may not be worth it.
However, if you want to give mutual funds a try, you could start small, just like with stocks. You could look for low investment fee mutual funds. Or start out with $50 or even less, which shouldn’t affect your budget by much.
Related article: Best investment advice for young adults
In a nutshell, investing in stocks, bonds or mutual funds boils down to this:
- stocks offer high returns, but imply big risks
- bonds imply lower risks, but offer smaller returns
- mutual funds offer returns somewhere in between, at a tolerable risk rate, but imply high management fees.
How and where should you invest your money is really a matter of personal preference. Talking it over with a finance professional should help beginners make an informed decision.
Do you have an investment portfolio? How did you get started?
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8 thoughts on “Investing basics: comparing stocks, bonds and mutual funds”
The best way to decrease the risk of stocks is through diversification. You can get extremely cheap diversification with an ETF. If I buy 500 companies at once then who really cares if one or two go bankrupt. That’s a 0.2-0.4% loss. The other 498 will see me through.
That’s a completely different story if you only invest in 5-10 companies. All of a sudden one company going bankrupt can wipe out 10-20% of your portfolio. That’s a risk no investor should be taking.
I also ‘believe’ in diversification, it’s like the a ‘key ingredient’ to successful investing. Beginner investors have a more difficult time though, starting small makes it more difficult to diversify your investments.
Nice breakdown of the investing basics. I find that many people find the idea of investing complicated and scary so anything we can do to educate them will only help.
I totally agree 🙂 I used to freak out when I heard about stocks and bonds and everything else. Turns out, once you understand some basics, investing isn’t that scary afteral!