Should I buy stocks or bonds? Here are the basics you need to know.
Wondering what to do with the rest of that bonus check, or the little bit of extra Christmas cash your grandmother tucked inside your holiday card?
While there's no substitute for the boring-but-necessary money steps like maxing out on your retirement contributions and fattening your rainy day fund, most portfolios are made up of two main assets: stocks and bonds.
Generally speaking, buying individual stocks and bonds isn't such a great idea.
It's just a whole lot riskier to put all your eggs in one basket, as opposed to a more diversified investment like an exchange traded fund (ETF) — which mixes up a lot of different stocks and bonds — or a good, old-fashioned 401(k), especially if the latter comes with employer matching.
Still, whether you've got some play money to work with, or you're trying to learn about how the market works, you may be ready to try and play the individual market.
Here are the basics you need to know.
What are bonds?
Both stocks and bonds are the two main ways that companies and the government raise money.
With bonds, investors give a company or the government money that gets paid back with interest over a set period of time (with stocks, on the other hand, the person handing over cash gets a share of the company). Bonds come in all different shapes and sizes, but there are a few main terms to know.
The first is the face value of the bond — i.e., is it a $50 bond or a $100 bond? That's the amount the bond is worth once it hits hits its maturity date, which is the date when the bond hits its full value. There's also the coupon rate, which is the amount of interest it pays; and the coupon dates, which is time frequency when those interest payments go out — usually once or twice a year.
One of the most popular kinds of bonds are treasury bonds or treasury bills, because they're backed by the full faith and credit of the United States. For that reason, they're seen as a more or less guaranteed investment. In effect, you're lending the U.S. government money, which it'll pay back with interest. U.S. bonds come in a variety of different time frames, ranging from a few months to decades, but generally they're sold at an auction price that's lower than the face value. Once the bond hits its maturity date, then it can be redeemed at face value.
Because they're such a safe bet, the returns on bonds aren't great. For instance, purchase price on a $1,000 T-Bill is likely going to be in the range of $950, depending on the term of the loan. That means the most you'll earn on them is around $50, a return of less than 1%.
"Stocks and bonds both have some risk tied to them, but generally, stocks are viewed as having more risk," said Roger Ma, a certified financial planner. "However, lower risk generally means a lower possible return."
Because of the stability they provide, the conventional wisdom is that you want to hold more stocks when you're young, and hold more bonds when you're older.
In other words, bonds don't really fluctuate with the market like stocks do.
Some economists disagree with this line of thinking. Michael Kay, a certified financial planner, says that with long term bonds where the maturation period is a decade or more in particular, there's good chance your investment will be outpaced by inflation or higher interest rates. For that reason, he recommends using bonds to save for short-term goals, like buying a house or starting a business — things you plan on doing no more than five years from now.
"If you're going through multiple cycles of interest rates going up and down, you can't predict what happens, you're most likely not getting paid back for the risk," Kay said. "Buying long bonds is typically a bad investment."
That's why, if you've got a long time horizon, you'll probably want a heavier allocation towards stock.
What is stock?
Stocks are the other main way that entrepreneurs and business leaders raise money to grow their business.
The idea is simple: Investors hand over cash for shares in the company, which entitles them to a share of future profits. Both private and public companies offer stock — the difference is who's eligible to buy it.
When you're buying and selling stock in a public company, the exchange is still the same. You're giving the company money so that it can grow, and in exchange you get a piece of the future profits.
The main virtue of buying stock is that when your cash just sits in the bank, it's not really doing anything. When you put your money into a stock, it's helping to hire people, create jobs, build new products and — if things go well — being transformed into something that's more valuable than the amount of cash you originally put in. This is what industry types mean when they talk about "putting your money to work."
Of course, stocks are a whole lot riskier than bonds, because there's no guarantee that the company is going to turn a profit and have money to give back to shareholders.
But they do provide a major opportunity for growth that bonds do not. For instance, if you bought $990 worth of Apple stock back in 1980 around its initial public offering price of $22 a share, that investment would be worth nearly $300,000 now. That doesn't include dividends, which is when a company makes enough of a profit to send a portion back to their shareholders.
Unfortunately, trying to buy the next Apple is a bit of a fool's errand, Kay cautions. You've got to get the timing right — a tall order when you're competing against highly compensated financial industry types with reams of information and tools at their disposal.
"So if you're smart, you'll just let the market do its thing and own a properly allocated mix, foreign domestic, large and small," Kay said. "Be a little bit of a contrarian. Don't follow the herd."
That sentiment is echoed in the below tweet from Josh Brown, a finance executive who tweets under the handle @ReformedBroker:
But understand that picking individual stocks with the intention of cashing out is likely a losing battle, and well-diversified investments like ETFs or mutual funds are a far safer bet.
"I'm fine with clients having a small portion of their portfolio in individual stocks, such as 5%," Ma said. "But I believe they are best served with low-cost, well-diversified portfolios."
There's a reason why so many financial advisors advocate this "buy and hold approach," which essentially means you find good investments, and hold them for as long as you can. The longer you hold the stock, the more likely it is that you'll catch multiple bull markets, which increases the odds of you coming out better than you started.