The Basics

The Basics

What is a…

 

Stock: a piece, or share, of a company. When someone buys a share of Apple’s stock, she is buying a tiny piece of Apple. Apple gets to use the money they get from issuing shares to improve their MacBooks and iPhones. As Apple earns more money, and its stock becomes more desirable, that share becomes more valuable: its price gets higher.

 

Now, the investor, the owner of the share, can choose to sell it for more than she paid for it. This is the pure foundation of investing. Holding stock in a company actually signifies partial ownership of the company. Stocks are sometimes also referred to as equities. The goal is always to sell the stock for more than you paid for it.

 

Bond: like a stock, when someone buys a bond, he is lending his money to the issuer of the bond (usually a company or the government). Unlike a stock, a bond has a fixed rate of return, guaranteed by the issuer. That rate of return is usually much lower than the returns one can hope for from investments in stocks. Risk is rewarded when it comes to investing, and stocks, which are riskier, have higher long-term returns than bonds.

 

The bond can be returned back to the issuer on its ‘maturity date’ for its face value. Example: If you buy a $100 bond, and it pays out a guaranteed 5% a year, you will be paid $5 a year. Let’s say the bond reaches maturity after five years. In five years, you will have been paid a total of $25, and can return the bond to the issuer for $100. You started with $100 and ended with $125.

 

Someone who owns a bond can sell it before the maturity date in the bond market. Let’s say stocks are having a bad year and generally falling in value, and you’ve got a bond that pays out 6% a year. Your bond is going to start looking pretty attractive to investors who are losing money in the stock market and lusting for the stability of bonds. You might be able to sell it now for more than you paid for it originally, without waiting until the maturity date.

 

Conversely, if the stock market is doing much better than the bond market, there might not be very high demand for bonds. You would hold on to your bond and continue to take your guaranteed payments, rather than sell it for less than what it’s worth to you. Your bond is less attractive because investors feel they can do better by investing in stocks.

 

Individual investors now typically buy bonds through funds, which are just bundles of several different bonds. By taking this approach, they diversify their risk in case one or more of the bond issuers defaults. Though bonds are generally  safer and more dependable than stocks, they carry the small risk of default, which is when the issuer can no longer afford to pay out the agreed upon amount.

 

When you buy a share of a bond fund, you don't have to wait for a maturity date or worry about selling your bond on the market. Your fund will grow in value, over the long-run, and when you're ready, you sell your share for (hopefully) more than you paid for it. It functions much like a stock- you buy and sell shares at your will- but remember, it's actually a bundle of bonds.

 

Mutual Fund: is commonly described as a basket of stocks. A mutual fund is just that, a group of some number of stocks; it could be 10, could be 1,000, etc.. When you invest in a mutual fund, your money is spread across the stocks of all of the different companies in which the mutual fund invests. (Just the same as we discussed with bonds.)

 

If I buy a $100 share of a mutual fund that invests equally in 100 different stocks, then each of those companies will get one of my dollars. This is one way to diversify risk. If one of those 100 stocks is Starbucks, and one day everyone realizes the coffee tastes awful, the value of Starbucks’ stock will likely plummet. However, I’ll still have at least $99 left! Not such a big deal. But, if I had put my entire $100 in Starbucks’ stock, I could've lost much or all of it.

 

Mutual funds are great for young investors. Young and/or beginner investors don't tend to have a lot of money. If I have $200 to invest and I want to invest in Apple, and a single share of Apple costs $130, I will be taking a lot of unnecessary risk.  If Apple's stock falls in value, so will most of my money. Instead, I could take my $200 and invest in a mutual fund that invests in lots of tech companies. I would then be invested in Apple, Samsung, Microsoft, etc.. Mutual funds allow investors with fewer dollars to invest in hundreds, if not thousands, of companies!

 

Index Fund: is a type of mutual fund. It’s a basket of stocks. There is a key difference here, and it’s in the word index. You may have heard of the Standard and Poor 500, or the S&P. The S&P is an index of 500 of the largest companies in the U.S.A. The index is not itself a fund, it merely tracks the total value of those 500 companies’ stocks all together. One way to measure the strength or success of our economy is to follow the movements of an index like the S&P 500, Dow Jones, or Nasdaq.

 

The type of investing that we describe and encourage at WLI is called passive investing. Passive investing involves investing in index funds. Typical mutual funds are active and run by managers. The managers do their best to pick stocks that are going to grow in value more than others. On average, these managers charge enormous and excessive fees to compensate them for all of their stock-picking work! The bad news for their investors is that over periods of time greater than 5 years, these managers do not manage to beat the market, a.k.a. to beat indexes like the S&P 500.

 

Passive index funds, unlike active mutual funds, bring dramatically lower (read: cheaper) expense ratios (a term for fees). This is because they are not employing managers to handpick stocks that they hope will be winners. Instead, index funds track our entire economy or segments of it. Long-term, our companies get richer, our economy grows stronger, and our stocks rise in value. By cutting out the managers who are statistically unsuccessful over long periods of time across the board—and very expensive—we actually outperform other investors by just buying the market.

 

Portfolio: simply means the stocks, bonds, mutual funds and other assets in which you invest. If Gambler-Ross decides to invest in Nintendo, Uggs, his uncle's typewriter company, and an Enron bond, his portfolio will just be those four investments.

 

Feel good? Go Deeper before embarking on your personal finance journey.

 

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