Before taking the leap into investing, you should understand the basics of how to invest money. Knowing how to invest means understanding the difference between stocks and bonds — two key investment options that can grow your money — and how they affect the performance of your overall investment portfolio. Here’s a quick look at both, plus information on how to determine the best investments for you.
Stocks vs. Bonds
Before exploring how to buy stock, you should learn what a stock is. Stocks represent ownership shares in a company. When you buy 100 shares of Facebook stock, for example, you actually own part of the company. Facebook has about 2.905 billion shares outstanding, so your 100 shares don’t reflect a large ownership portion; however, you would still participate in the same percentage gain or loss per share as CEO Mark Zuckerberg himself.
If stocks are shares in a company, what is a bond? A bond represents a loan you make as an investor to a company in exchange for interest paid on the bond until maturity, when the company pays back the principal. Different types of bonds are available, ranging from Treasury bonds issued by the U.S. government — considered among the safest types of bonds — to corporate bonds issued by individual corporations. Like stocks, bond prices can fluctuate based on various factors.
A bond investor typically seeks income and security, and in fact, investing in bonds is often considered a more conservative option than investing in stocks. But bonds do carry risk. Bond risks include interest rate risk, in which rising interest rates reduce the market value of the bond, and credit risk, which is the possibility that a company won’t be able to pay you interest or principal.
To understand what type of return to expect, investors turn to the bond yield. Yields can be measured in a number of ways, including coupon yield, or the stated interest rate of the bond, and yield to maturity, which is the total rate of return when an investor holds the bond to maturity.
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How to Choose the Best Investment for You
Before you dive into investing, you should review your financial situation and develop a financial strategy so you can choose the right investments for your situation. Here are a number of different variables to consider before choosing your investments:
- Your age
- Your financial situation, including net worth and annual income
- Your time horizon, or how long you intend to invest
- Your financial goals
- Your ability to tolerate risk or price fluctuations of investments
- Your investment experience
- Your tax rate
- Other investments you might already hold, including those in retirement accounts like a 401k
Ultimately, your investment objective should guide your ratio of stocks to bonds. For example, if your goal is to achieve capital gains, you’re a growth investor. Generally, investors looking for growth of capital will seek out a stock-heavy portfolio. If you prefer getting a monthly paycheck from your investments, you’re an income investor. Income investors typically tilt their portfolio toward bonds.
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An honest assessment of your risk tolerance can help you determine your proper stock-bond balance. Stocks have had higher long-term performance than bonds, but they are much more volatile. In the short run, you could face substantial losses. However, bonds are not guaranteed to provide income. In a rising interest rate environment, bond prices will go lower.
Because no one can forecast the future of the stock and bond markets, many experts recommend that investors have a balanced portfolio, for the simple reason that diversification lowers risk. For example, some investors increase their bond allocation not because they need the income, but because they want to diversify away the risk of an all-stock portfolio.
How to Buy Stocks and Bonds
Once you’ve got your allocation, you’ll have to do further research to analyze specific bond and stock options. For this step, many investors use the assistance of a financial advisor, especially if they’re a beginner.
Once you’ve balanced your portfolio between stocks and bonds, however, you’ve done most of the heavy lifting when it comes to finding the best investments. A recent Wells Fargo study suggests that 96 percent of performance is attributable to strategic and tactical asset allocation, rather than the selection of individual investments or other variables. In other words, focus on keeping your portfolio balanced between your desired mix of stocks and bonds, rather than which stocks and bonds to choose.
To buy either stocks or bonds, start by opening an account at a brokerage firm. If you need investment advice, you might be interested in a full-service firm, which provides advice tailored to your situation, security selection and other services. Discount brokers charge lower commissions for buying and selling stocks or bonds, but keep in mind that they offer fewer services.
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