Before we can decide if we want to invest in stocks, bonds, and mutual funds, we need to know what they are. Stock is simply ownership of a company. A company might divide its ownership up into one million little pieces, or shares, and then trade those shares on the open market. If you own one of these shares, you own a little piece of that company, and are entitled to your share of the privileges of ownership. When the company announces higher-than-expected earnings, it may divide up those earnings among its owners. And because you own a share of the company, you’ll get a share of the profits. When the company announces a new product, the price of your share may go up. You could sell your share and make a little profit, or you could hold on to it and hope it goes up ever more. Of course, it could go down, too, and this is the danger with stock market investing.
While stocks represent the ownership in the company, bonds represent the debt of the company. When a company wants to borrow money, it might issue a bond, which is simply a promise to borrow money and repay it at a later date, with small interest payments along the way. If you own a bond, you’ve loaned the company some money, and they will make payments to you – the same way you make payments on your loans. One danger with bonds is that the company could default on its debt and leave you holding the bag.
Since there are so many different companies offering their stocks and bonds to the public, and since there are dangers inherent in this kind of investing, how do you know which specific stocks and bonds you should invest in? Wouldn’t it be better to own a basket full of different stocks and bonds, so that if something bad happened to one company, you’d still have a pretty full basket? That’s the idea behind mutual funds. A mutual fund is a giant basket containing dozens or even hundreds of different stocks and bonds. Owning a share of a mutual fund is much like owning a share of a company, when the stocks and bonds in that fund do well, you get a share of the profits. By yourself, you might never be able to invest in so many different companies, but when you pool your money with thousands of other investors, you can own great positions in many companies.
This post originally appeared in the November 21, 2007, edition of the Greenhorn Valley View.