Investing isn’t as hard as most people think, but there’s a lot of jargon to learn. Stocks and bonds are two common terms that come to mind when you think about investing. Many people don’t know the difference, so we’re going to break it down.
Stocks Buy Ownership, Bonds Buy Debt
For most of us, the obtaining the dream of retirement means investing our money so it can grow over time. While there are specific types of investments, stocks and bonds are two general categories you should be invested in.
In basic terms, a stock is a piece of ownership in an individual company. This is also known as equity. When a company goes public, like Microsoft, Google, or General Motors, they sell shares of their business to the public. You buy a share, the company gets your cash to build their business, and in turn, your share represents a small piece of ownership in the company. If the company does well, like Google has over the years, they make a profit and your shares of ownership increase in value. If the company tanks, like Volkswagen has recently, your shares decrease in value (or worse, you lose them altogether).
Of course, if a company is flourishing, you can expect the shares to be more expensive. A single Google share will cost you over $800 right now, whereas a share in Volkswagen is less than $150 right now. Those numbers fluctuate over the years, depending on how the company performs.
And then there are bonds. When you buy a bond, you’re basically buying a debt and loaning a company (or government) money. Instead of investing in the company itself, you give them money and they agree to pay you interest. This interest is called a “coupon,” and it’s paid at a set rate and schedule. The bond also comes with a maturity date: the date the issuer has to repay the amount they borrow. You can also sell your bond before the maturity date. Depending on what interest rates look like when you sell, you might get more or less than what you paid.
Because bonds are predictable this way, they’re called fixed-income securities. Investopedia explains:
For example, say you buy a bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years. This means you’ll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you’ll receive two payments of $40 a year for 10 years. When the bond matures after a decade, you’ll get your $1,000 back.
You won’t earn a huge amount of interest, but you more or less know what you’re getting with a bond. In short, when you buy a stock, you buy equity, and when you buy a bond, you buy debt.
When you buy a stock, you could earn a big return if the company does well and your shares increase in value. If you bought a share of Google back in 2004, for example, you paid $50 per share. Three years later in 2007, that same share was valued at about $300. If you sold your share, you would make a $250 profit. Not bad. If you waited until 2017 to sell, though, your share would be valued at about $850, so you’d profit $800 from a single share. Nice! Most people don’t just buy a single share, though. So if you bought 50 shares of Google back in 2004 (which would’ve cost you $2,500), those same shares would be valued at over $42,000 now. You can see how stocks are an excellent way to grow your retirement savings.
Then again, not every company is Google.
There are so many factors that could affect a company’s profitability, from recalls to new technology to the way consumers decide to spend their hard-earned money. For this reason, stocks are generally considered a riskier investment, especially in the short-term. In exchange for your risk, though, you get more reward. For example, according to investing site Zacks, stocks have earned about 9.18% annually from 1959 to 2008, and bonds have earned an annualized return of 6.48% for that same period.
Of course, that’s a generalization and the performance of a stock will vary quite a bit depending on the company. That’s sort of what the S&P 500 is for. It’s a financial index that’s made up of 500 of the most economically powerful companies in the United States. They can drop or rise in value day-to-day, but over the years, these companies have performed pretty well, making them a less risky long-term bet, since they’ve held their value pretty steadily. It’s also worth noting that investing all of your money in a single company is probably a bad idea. Most experts recommend mutual funds, groups of investments in a number of different stocks.
Again, you more or less know what you’re getting with bonds. They’re considered to be safer investments than stocks, but they don’t earn much money. If all of your retirement savings are invested in bonds, you’re probably not going to earn much over the years.
As you get closer to retirement, though, you want to invest less in stocks and more in bonds. You don’t have as much time to be risky.
How Much You Should Invest in Both
There’s a lot more to investing beyond stocks and bonds, but these are the basic, general types of investments you should have in your portfolio. So how much should you invest in each category? That depends on your age, investment goals, and risk tolerance, but here’s a common rule of thumb:
110 – your age = the percentage of your portfolio that should be stocks
So, if you’re 30, you’d put 80% of your portfolio in stocks (110 – 30 = 80) and the remaining 20% in lower-risk bonds. If you’re more conservative, however, you may want to put 30% in bonds instead. It’s up to you, and some people think this is too conservative, but it’s a good starting point.
As you grow older, you should adjust these percentages accordingly. If you’re following the 110 rule above, you’ll want to buy more bonds when you’re 40, so that you have 30% in bonds instead of 20. The closer you get to retirement, the more stability you need in your investments. You don’t have as much time to take risks, in other words. If your stocks fail, you only have so many years to wait until they bounce back again.
There are also plenty of tools that can help you figure out how much to invest in each. Bankrate’s asset allocation calculator works well, or you can use a full-service investment tracker like Personal Capital.
There’s a lot more that goes into investing, of course. There are different categories of stocks and bonds. There are different ways stocks pay their shareholders. These are the basics, though, and if you’re a beginner investor, it’s important to learn the difference in how these two fundamental assets work to help grow your nest egg over time