Stocks, Bonds & Mutual Funds: A Beginner's Guide to Investment

Stocks, bonds, and mutual funds are well known and powerful components of a diversified portfolio. To achieve desired returns to accomplish goals, it is extremely important to make sure there are different types of investments in a portfolio.

Summary

• When an investor buys a stock, part ownership in the form of a share is bought.
• Bonds are a type of investment designed to aid governments and corporations to raise money.
• In a mutual fund, money collected from various investors is taken together to buy a large variety of securities.

What is a Stock?

When an investor buys a stock, part ownership in the form of a share is bought. If the business or enterprise happens to do well, the investor benefits by seeing an increase in the value of the share. The share can either be held or sold at a profit on the stock exchangeNew York Stock Exchange (NYSE)The New York Stock Exchange (NYSE) is the largest securities exchange in the world, hosting 82% of the S&P 500, as well as 70 of the biggest. If the business does poorly, the value of the share declines, and the investor may lose some or all of the investment.

Stocks are usually riskier than bonds as there is no guarantee that the stock will do well. However, there is potential to earn higher returns when it comes to stock trading. Companies sell their stock for various reasons, such as developing new products, expanding into new markets, or even paying off debt. The first time a company sells stock is called an initial public offering (IPO)Initial Public Offering (IPO)An Initial Public Offering (IPO) is the first sale of stocks issued by a company to the public. Prior to an IPO, a company is considered a private company, usually with a small number of investors (founders, friends, family, and business investors such as venture capitalists or angel investors). Learn what an IPO is.

What is a Bond?

Bonds are a type of investment designed to aid governments and corporations to raise money. It can be viewed as a type of loan. There is no stock ownership and dividends, but investors who purchase bonds do receive payment in the form of interest.

For example, Company A needs to raise $2 million for a certain project. It decides to offer a 3-year bond to investors to raise the money. The investor will then purchase the bond at the issue price, and Company A will pay the investor interest on the money paid for the bond. Once the bond matures, the company will pay the face value of the bond back to the investor.

Therefore, bonds are fixed-income assets, unlike stocks. The percentage of interest is fixed in advance. Bonds are rated by credit rating agencies such as Moody’s and Standard and Poor to help investors.

There are broadly two types of bonds, government bonds and corporate bonds. When the government is in need of money, they can only issue bonds. Businesses issue bonds instead of seeking a loan or overdraft from the bank as interest rates are cheaper on bonds and the bond market offers better terms.

Stock vs. Bonds

When bonds and stocks are compared, bonds are considered to be a safer investment. It is important to note that bonds are not completely risk-free and only receive preference in case of bankruptcyBankruptcyBankruptcy is the legal status of a human or a non-human entity (a firm or a government agency) that is unable to repay its outstanding debts.

Owning a stock offers more potential for returns, but bonds come with much less downside volatility. Bond investments play a key role in balancing and reducing the short-term volatility associated with stocks.

Mutual Funds

Stocks and bonds are characterized by asset classes. On the other hand, mutual funds are pooled investment vehicles. In a mutual fund, money collected from various investors is taken together to buy a large variety of securities. A mutual fund gives an investor instant diversification.

Mutual funds are not the same as stocks. When you invest in a mutual fund, you do not own shares of the stock invested in but own a piece of the fund. Furthermore, mutual funds are usually managed by fund managers in financial corporations. Once an investor purchases a fund, there is no control over what goes in or out of the fund. Therefore, there is no investment in a particular stock or bond but a combination of various assets. There is also a fee or commission to be paid.

Key Takeaways

Investors do not decide between stocks and bonds but decide on the proportion of the two in their portfolio. As stocks and bonds come with their own pros and cons, an investor will decide on the proportion according to the desired goals and risk tolerance.

Once decided, the investor then decides on which vehicle to use to implement such asset allocation choices. The investment vehicle can be mutual funds, exchange-traded fundsExchange Traded Fund (ETF)An Exchange Traded Fund (ETF) is a popular investment vehicle where portfolios can be more flexible and diversified across a broad range of all the available asset classes. Learn about various types of ETFs by reading this guide., or individual securities.

There is no single investment channel that is best for any investor. Investments are usually based on four criteria, namely age, income generation, length of time until the money is required, and risk tolerance.

More Resources

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In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• DiversificationDiversificationDiversification is a technique of allocating portfolio resources or capital to a variety of investments.The goal of diversification is to mitigate losses
• Asset AllocationAsset AllocationAsset allocation refers to a strategy in which individuals divide their investment portfolio between different diverse categories
• Multi-Asset ClassMulti-Asset ClassMulti-asset class is a phrase used to signal that an investment is made up of a combination of asset classes (such as cash equivalents, equities, or bonds)
• Investing: A Beginner’s GuideInvesting: A Beginner's GuideCFI's Investing for Beginners guide will teach you the basics of investing and how to get started. Learn about different strategies and techniques for trading