Stocks and Bonds

Stocks and Bonds – Introduction to the Basics

If you want to start investing, it means you’re looking to put resources into something that will generate returns in the future.

There are plenty of things we can invest in, and not all of them are of financial nature. However, the term is usually associated to allocating money in tradable financial assets, called securities.

In this post we will cover the most common ones:

What Are Stocks?

Stocks are securities that represent ownership in a corporation.

The amount of the ownership is relative to the total number of shares of that corporation, called the outstanding shares.

People use the terms stocks and shares interchangeably but they’re not the same. Stocks is more general, while shares is more specific. For example, if an investor says that he owns stocks, he would refer to having ownership in multiple companies. While if he says he owns shares, he would refer to an ownership in a specific company and would add the word “in” after the claim: “I own shares in Tesla“.

Why Companies Sell Ownership?

The reason for issuing shares in the first place is for companies to raise capital. Investors exchange cash for an ownership stake in the company.

Buying shares when they are first issued is called buying shares in the primary market. This happens only once – when the company goes public (i.e. becomes a publicly traded company).

Most of the trading happens on exchanges though. This means that investors buy the shares from other investors – in the secondary market.

This is what you’d be doing if you proceed on your journey.

Dividends

A dividend is a distribution of the company’s profits to shareholders.

The dividends are paid “per share”. The ratio between the dividend per share and the price of a share is called dividend yield.

For example, if a company has a share price of 100$ and pays 10$ per share in dividend annually, that means that the company’s dividend yield is 10%.

Some companies don’t pay dividends but reinvest the profits in the business itself. This has an effect in the price of the shares, as it’s an amount that stays in the company.

Investing in Stocks

Let’s say you bought shares from a specific company, at a specific time, at a specific price.

If the company performs well, its stock will go up and your portfolio will increase in value. However, the value of the shares can also go down and, theoretically, you can lose everything. Basically, your investment represents how right you were when assessing the business.

There are various parameters you can use to analyze businesses, but these are out of scope of a post containing the word “Stocks and Bonds – Introduction to the Basics”. But have in mind that most of the information you’d need for publicly traded companies is already available to you. For example, you can click here to see the details for Apple by going in the “Statistics” tab or do a simple google search of any company of interest.

But don’t jump to any conclusions just yet. Keep in mind that stock picking is risky, maintaining a portfolio of tens of companies is hard and time consuming, and timing the market is almost impossible.

So for now, focus on understanding what stocks are and what they represent. The ways to build a robust portfolio come later in this series.

If you’d prefer a more structured source, keep reading – I have something for you at the end of this post.

What are Bonds?

Another way for companies to raise money is through borrowing.

Bonds are securities issued by corporate or government entities to raise capital by loaning money from investors.

When you purchase bonds you become a lender to the bonds’ issuer.

The investors entitled to a fixed or variable interest, paid annually or semi-annually. They’re also entitled to repayment of the loaned funds at a specific date in the future. After this date, called the maturity date, the investors stop receiving interest.

For example, let’s say you buy a bond for 1000$. Let’s say this bond pays 10% fixed interest and has a maturity of 10 years. That means that you will receive 100$ every year and you will get your 1000$ back after 10 years.

The interest rate paid on bonds is called a coupon and the value owed by the issuer is called principal. Some bonds don’t pay interest (called zero-coupon bonds), but are sold at a discount and repaid in full at maturity.

Older investors and people who want to have less risk exposure, usually allocate a larger portion of their money in bonds.

Bond Rates

The interest rate mainly depends on the credit quality of the bond’s issuer and the bond’s time to maturity.

The credit qualities are assigned by credit rating agencies such as Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings. A credit rating represents the creditworthiness of the borrower – the ability of the bond issuer to pay back the debt. This is more than enough detail for the purposes of this post, but in summary, a one year bond from an AAA company (highest credit score) will pay a lower rate than a 30 year bond from a B- rated company.

Bonds are considered less risky than stocks. In case of bankruptcy, the company has a legal obligation to repay the creditors with highest priority. On the other hand, the shareholders are at risk of losing everything. However, the bond owners receive the interest payments as agreed when purchasing the bond. But this also means that even if the company increases in value, their returns remain fixed. Shareholders, on the other hand, have unlimited earning potential.

Stocks and Bonds: Closing Thoughts

Stocks and bonds are the most common instruments in investors’ portfolios.

Spend enough time to understand the basics because whatever knowledge you acquire in the future would be built on these fundamentals. So make sure they’re as robust as possible.

And don’t forget to do your own research from sources outside my blog.

In my book, Become an Investor: The Ultimate Guide to Long-Term Investing for Absolute Beginners, I have a separate chapter dedicated to stocks and a separate one for bonds. I go in detail into everything you need to know to kick-start your investment journey.

Alternatively, subscribe below to get email updates every time I release a next part of this series.