What Are Stocks And Bonds?

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Simply put, stocks are a way for you to own a part of a company. Bonds are a way for you to loan money to a company, government or other organization.

When you buy shares of stock, you become one of the owners (a shareholder) and actually own a part of the company that issued the stock. As one of the owners, you may:

• Help choose the company's leadership.
• Share in the company's profits if it chooses to distribute periodic payments called dividends.
• Have the potential for gain or loss if the value of the stock increases or decreases.

When you purchase a bond, you are essentially making a loan to the bond's issuer. Bonds are issued by companies, churches and federal, state and local governments. As a bondholder, you may:

• Receive interest payments from the issuer of the bond.
• Receive the face value of the bond on its maturity date.
• Have the potential for gain or loss if the value of the bond increases or decreases.

Risk And Reward

Generally, the more risk an investor takes with a given investment, the greater the potential for growth.

Generally, stocks are considered to be riskier than bonds because their value tends to fluctuate more.

Every investment has some element of risk. The relatively low returns associated with an insured bank savings account, for example, leaves the investor exposed to purchasing power risk. This is the risk that the buying power of your assets will decline over time if your investment returns do not equal or exceed the rate of inflation.

Imagine you are choosing between two investment alternatives. Both promise to pay you 5 percent interest but only one guarantees the return of your original investment. Since both pay the same rate, you would naturally choose the guaranteed option. However, if the second investment offered a 10 percent interest rate, you might be willing to do without the guarantee. You may be willing to accept more risk in exchange for the possibility of the additional reward of 5 percent.

Deciding the mix of stocks, bonds and cash that is right for you depends on a variety of factors.

• Readiness for emergencies. Before investing in longer-term assets, you should first create an emergency fund. Financial planning professionals recommend targeting 3 to 6 months of basic living expenses — enough money to manage a crisis without borrowing money.
• Timing of your goal. The sooner you will need to use your money, the less risk you can afford to take.
• Your personal risk tolerance. Never invest more than you can afford to lose.

Three Ways To Invest

There are three primary ways to invest in stocks and bonds.

• Directly, by buying individual stocks or bonds selected by you or your financial planning professional.
• Indirectly, by investing your money in a mutual fund, which in turn invests your money in a portfolio of stocks, bonds or a combination of the two selected by the fund's manager.
• Indirectly, by investing your money in Exchange Traded Funds or ETFs. ETFs are a new and very popular way to invest in stocks and bonds. They are like a mutual fund in that they hold a diversified portfolio of stocks and/or bonds but they are bought and sold like stocks.

For More Information

The USAA Educational Foundation publication, Mutual Funds, offers more information.