Key Takeaways
- A stock is a share of ownership in a company, whereas a bond is a debt instrument with a set interest rate, time frame, payment intervals and principal payment at the end.
- Risk and reward are key with stocks and bonds. Stocks are riskier, with the reward greater, as well as the possible loss. Bonds make consistent money and you tend to get some back if the company doesn’t fare well.
- Stocks and bonds are risky investments, but it’s important to know their uses.
Sometimes it’s easier to learn about intangible things, things we can’t feel or touch, in terms of a story. The following story is about Sara, Samantha, and Mike.
Sara has saved up $40,000. Samantha, a friend of hers, comes to her and says, “I’m starting an e-commerce company and I’m asking you for $10,000.” Sara says, “I’ll do that, but I want 10% ownership in your company.” Samantha agrees and gives Sara a stock certificate.
About 6 months later, Mike comes to Sara and says, “Hey, would you like to invest in my company for $10,000?” Sara says, “You know what, I don’t want stock, but I will lend you the money in a loan, in debt, that you could pay me back in 5 years at 10%.”
So, what’s a stock? Stock is share of ownership in a company of any size, and it also goes by the names equity, or shares.
A bond on the other hand, is a debt instrument. It’s issued by corporations, government, and municipalities. It’s usually a set interest rate, over a set number of years, where you’re paid in interest monthly, semi-annual, or annually and you’re paid back the principal at the end of that time frame.
What happens in a good scenario with our friends 5 years later?
Samantha triples the company and gives $30,000 back to Sara. Sara made $20,000 on the stock deal with Samantha.
Mike as well tripled his company, but in this case, he gives Sara back $10,000 at the end of five years along with the $1,000 he paid her annually over 5 years.
Sara made money on both deals, but she made more on her deal with Samantha because of the higher reward a stock option in a successful company made her. What happens in a bad scenario?
Samantha’s company goes under. Sara gets nothing.
Mike’s company goes under and he had a bunch of furniture, computers and other property that gets sold on eBay, so Sara stands in line with the other creditors. Maybe she gets 50 cents to 80 cents on the dollar, so she gets something back.
With higher risk comes both higher rewards, and the potential for greater losses. Sara lost her entire investment in Samantha’s company with a stock deal, whereas she received some of her money back in her bond deal with Mike.
These kinds of investments are very risky, so they are not generally recommended when it comes to searching for ways to invest your savings or retirement money. However, it is good to know the difference between stocks and bonds, their risk and reward factors, and the kind of instrument that a stock and a bond is.
When you are putting together a plan based on your goals, your objectives, and how you want to see your money grow, it’s very important to understand what’s a stock, and what’s a bond.
Until next time, enjoy.
Gary
