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Friday, February 03, 2023

College 101: Stocks or Bonds

When most people think of investing, they think of stocks and bonds. But what’s the difference between the two? And what are mutual funds and ETFs? Stocks and bonds have a few things in common, but there are important differences. Let’s discuss stocks and bonds first, then move on to the slightly more complex topics of mutual funds and ETFs.

Stocks and bonds

Stocks and bonds are both ways for companies to raise money. They’re also both ways for investors to profit off of that process. But there is a fundamental difference in how they work. Bonds act a little like loans, while stocks act essentially as ownership shares in a company.

Let’s say you ran a company and needed some cash. You could get some by securing investors--literally selling a portion of your company to newcomers, then using the profits of those sales to fund your company. Do it right, and your next big project might increase the value of your company enough to make up for the portion lost--while also making the shares your new investors bought worth more than what they bought them for. When a company issues stocks on the stock market, this is what they are doing.

But let’s say you don’t want to offer shares--or perhaps you already have, and don’t want to part with any more. In this case, you could go get a loan. But a really, really big loan might be too much to ask--unless you split it up. Lenders could arrive and bid on portions of the loan, essentially buying a share of the debt. You’ll pay back, with interest, the amount that corresponds to the shares a buyer owns--unless your company goes belly-up, of course.

This, of course, is how bonds work. Companies and governments can issue bonds. They say how much they’re worth on them, but their value on the market will depend on how likely folks think it is that the issuing entity will pay the bill!

If a big, giant company issues a bond and you buy some, you can be pretty sure you’ll be paid back. Similarly, you could buy bonds that are about to “mature”--that is, the bill is about to come due--and target ones that everyone is pretty sure will be paid off. If you do this, you’ll have some nice, safe bonds, and you’ll get lower but more secure profits. This sort of bond investing is what a lot of us think of, but it’s important to remember that bonds are not universally “safer” than stocks. You can easily take risks in the bond market by looking for shaky companies or bonds that have a long way to go before they mature. And you can take fewer risks in the stock market by targeting big “blue-chip” companies.

Speaking of risks, they’re lower if you spread your money around. It’s safer to invest in all of the tech companies than in just Amazon, for instance, because even a huge company like Amazon can have problems. And it’s safer still to invest in multiple types of companies--not just tech companies, but industrial ones, manufacturers, banks, and so on.

Mutual funds and ETFs

But stocks aren’t cheap. How can a small-time investor achieve such diversity? One answer is the mutual fund or exchange-traded fund (ETF). While there are differences, both of these investment vehicles are funds that own lots of stocks and allow investors to buy shares in the fund--essentially placing a bet on the whole collection that the fund has. This can be used to lower risks, but it doesn’t have to. If you were a superstar investor, for instance, using advanced strategies like an RSI trading strategy, maybe you’d rise through the ranks of a finance company and eventually run a fund of your own. You could be as risky or safe as you wanted, and investors who chose the fund would be putting their trust in you (not blindly, of course: you can see all types of information on funds before you invest).

This is a broad look, of course, and there are other intricacies that are worth looking at if you are willing to do further research. But hopefully we’ve given you a good sense of how these investment vehicles work!

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