Anyone about to enter into the market for the first time is probably feeling skittish right about now. Wall Street flailed through an unprecedented crisis while Congress struggled to please everybody in the biggest financial bailout in the country’s history. When things didn’t go as planned, September 29th saw the largest one-day drop in the market’s history. Markets still have not recovered, despite an 11th hour $700 billion rescue plan Congress hammered out to prevent a real catastrophe.
But even during the Great Depression, opportunities existed in the midst of crisis and the worst economic scenarios have a way of bouncing back. As President Franklin Delano Roosevelt famously said at the time, “The only thing we have to fear, is fear itself.”
Since underlying investment principles remain the same throughout market peaks and valleys, we thought we’d offer a general overview of stocks and bonds now, so that first-time investors will be more prepared when they feel the time is right to take the plunge.
When investors first enter the market, they typically wonder which investments are right for them: stocks, bonds — or maybe a little of each. Most new investors don’t fully understand the difference between these two vehicles, much less how they fit into a long-range investment strategy.
If the question is which instrument is the wisest choice, the answer depends on investment goals and risk tolerance. But if the question is which security is better, the answer is neither.
Stocks and bonds each have their own merits — and their own risks. Since they differ dramatically in their structures, payouts, returns and risks, it’s important to weigh the risks versus the potential benefits. While stocks have a greater potential to increase in value—theoretically they have an unlimited ability for appreciation—they’re also more volatile and subject to more pronounced market fluctuations.
On the other hand, a bondholder generally knows the maximum expected return on their investment, especially if it is held to maturity. Even though a bond can sell at a premium prior to the maturity date, the return can never match that of stocks. High-grade bonds carry less risk but offer a relatively low yield.
Note carefully: Neither option is free of risk. Buying either stocks or bonds involves risks. As mentioned, stocks have virtually no ceiling (a stock you buy for a dollar might someday be worth thousands), but they can just as easily decrease in value and even become worthless. Bonds have their own set of risks as well. The bond issuer might default, for example, if it becomes impossible to make interest payments or even to return the principal to bond holders.
Choosing the right mix between stocks and bonds can be one of the most basic yet perplexing decisions facing any investor. In broad terms, the role of stocks is to provide the potential for long-term “upside” growth and the role of bonds is to produce a more stable income stream and reduce overall “downside” risk. The challenge is how to fit both investment vehicles into an overall strategy.
To help you understand the differences, here are a few key points you’ll want to know about stocks and bonds before you make a purchase.
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What Stock Ownership Means
When you buy a stock, you’ve actually purchased a piece of the company. As part owner you can now participate in the company’s profits. But because profits are directly linked to the performance and growth of the company, there are no guarantees on how much, if any return you’ll see on your investment.
Some stocks are riskier than others. So-called blue chip stocks are perceived to present less risk since the companies issuing them are well-established businesses with long track records, solid earnings and reliable dividends.
On the other end of the scale are the small capitalization, or small cap stocks. Since these companies are not yet fully developed, they often have greater potential for growth compared to established blue chip stocks. Investors in small cap companies hope this potential will translate into larger returns for investors, and are willing to accept the higher risk of loss involved.
It’s not only important that you understand the benefits and risks of owning stock, it’s also helpful to know about the two most common classes of stock: common and preferred. Each class has its own financial terms and shareholder rights in relation to governance of the company. Here are some of the key differences between these two types of stock.
Common Stock
As a common stock holder, you’re potentially eligible to receive two main benefits: capital appreciation and dividends. Capital appreciation means the stock's value has increased since you originally purchased it and you can reap a profit if you sell it at the higher price.
Dividends are payments paid to shareholders out of the company’s earnings. Typically paid quarterly, dividends must be declared as taxable income. Since dividends are paid based on the company’s continued ability to turn a profit, ongoing dividend payments can’t be guaranteed.
Holders of common stock also have the right to vote on major company issues and to elect members of the organization's board of directors. Shareholders are entitled to one vote per share owned. The downside is that is if the company is forced into bankruptcy, the common stock holder has to get in line behind the company’s creditors, bondholders, and preferred stockholders before they receive any payments.
Preferred Stock
Like common stock, preferred stock represents ownership in a company, but preferred stock does not come with voting rights or the same profit potential as common stockholders. Preferred stock is considered a more stable investment because dividends are guaranteed.
While the price of common stock is subject to the whims of the market, the price of preferred stock fluctuates with interest rate levels. As interest rates rise, stock prices go down and vice versa.
As mentioned, preferred stock has priority when it comes to the payment of dividends. If a company is forced to liquidate its assets, preferred stockholders get paid before those who own common stock.
Preferred stock comes in more than one size:
| • Participating preferred stock holders may receive dividend increases if common stock dividends exceed those of preferred stock dividends paid within a given year. |
• Adjustable-rate preferred stock is tied to shifts in other rates such as Treasury bills.
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| • Convertible preferred stock has a pre-set conversion price at which the preferred stock can be converted to a company's common stock. |
| • Straight or fixed-rate perpetual shares have no maturity date and the dividend rate is set for the life of the stock. |
Companies may have reasons to issue multiple classes of preferred stock, each with its own set of rights—Group I Preferred, Group II Preferred, and so on.
It may seem that being a preferred stockholder is more alluring because of all the options and guarantees available. But if you’re a beginning investor it’s better to stick with common stocks for a few years before venturing into the more complex choices available with preferred stocks.
Timing is also an important factor to consider. If you’re making a long-range plan toward retirement, conservative blue chip stocks have the advantage of time for slow steady growth in value. However, regardless of your age, concentrating too heavily on stocks might cause you to miss the benefits inherent in bonds.
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Bonds
When you purchase a bond, you’re not becoming a part owner, as you would when buying a share of stock. Bond buyers basically loan money to a company (or a branch of government) in return for a set amount of interest. Think of a bond as an interest-bearing IOU. A bondholder receives a check from the company at pre-set intervals, typically monthly or quarterly, until the "loan" is paid off when the bond reaches its maturity date. Another important difference: Bond holders have no say in company operations, and no right to vote on such matters as electing directors to the board.
The interest rate paid to a bondholder depends on the financial strength of the issuer. For example, a blue chip company is more stable and has a lower risk of defaulting on its debt, therefore pays a lower interest rate to the investor. Conversely, the higher the risk, the higher the interest paid.
Corporate bonds usually pay more interest than government bonds but they also carry a greater risk of possible default. As stated earlier, if a corporation goes bankrupt, bondholders have a priority claim on the company's assets, ahead of stockholders. That’s because they are treated as creditors, not owners.
Each bond is sold with a stated interest rate—the coupon rate—which represents a percentage of the original offering price. Bondholders don’t benefit from a company's profits, but they do receive a fixed rate of return on their investment.
Since bonds pay interest at set intervals of time, this can provide income for retirees or others who need the cash flow. For instance, if someone owned $100,000 worth of bonds that paid an annual interest rate of 8 percent, they would receive $8,000 yearly. The checks received could be used for living expenses or reinvested elsewhere.
Bonds have specified maturity dates—sometimes up to 30 years. Most investors feel that, at least for the short term, bonds offer greater security and return. But when maturity dates are longer than 10 years, the picture changes. The stock market has consistently outperformed bond investments over time. As companies continue to increase in value any short-term fluctuations in the stock market tend to even out.
Companies that issue stocks are selling part of their company to investors, whereas bond issuers are able to raise capital without giving up control of the company. Bonds, like common stocks, can fluctuate in market value and, if they are sold prior to maturity, could result in a gain or a loss in principal value.
The primary risk with bonds is that the issuer may not be able to make payments on time, or at all. Potential investors can check with rating with agencies such as Moody's Investors Service or Standard & Poor's to assess the issuer’s ability to meet its debt obligations.
Building a Portfolio: It’s Your Decision
When making investment decisions, most beginning investors would do well to start with combination of stocks and bonds in their portfolio. With diversification, you can lock in the relative safety of bonds while balancing the possibility of higher returns in your stock investments. A balance of stable, fixed-income investments could help off-set any stock market slides and well-chosen stocks could provide growth potential over the long term.
Most financial advisors suggest that investors think of building an investment portfolio as if it were a pyramid, with reliable, “blue chip” stocks and bonds forming a solid foundation, say 50 percent of the total value. On top of this foundation you’ll add a mix of growth and income stocks that are somewhat riskier but promise higher overall returns, adding to about 30 to 35 percent of your total investable assets. At the top of the pyramid, a small amount of money, say 15 to 20 percent of the total, is available for “high flying” growth stocks, where you can win big, but can afford to lose. (We have referred throughout to stocks and bonds, but the same principles apply to allocating assets among a variety of mutual funds.)
As time goes on, your investing objectives are likely to change, of course. Those reaching retirement, for example, are likely to change the mix of investments in their portfolio, moving toward more conservative investments that produce a stable income stream. At that point the pendulum may swing toward bonds and away from stocks. All the way along, though, these are your decisions to make.
