Stocks, Bonds, and Cash: The Basics

For many people, the world of stocks, bonds, and cash is shrouded in mystery – yet they are the building blocks of most investment portfolios. The following is a layperson's guide to key concepts and terms. You'll be amazed at how uncomplicated they can be…

Stocks
What they are: A share of stock represents a percentage of ownership in a corporation. In other words, if a company is divided into a million shares and you buy one share, you would own one millionth of that company.

The two basic types of stock are "common" and "preferred." If you own common stock you may vote on such issues as the company's business objectives and board members. Preferred stockholders do not have voting rights, but instead may receive dividends – quarterly payments made from the company's earnings. They also get preferential treatment in the event of a bankruptcy.

Why have them: Stocks are an important part of many people's investment portfolio because they have the greatest potential to make the most amount of money. However, stocks are inherently volatile. One day your stock may be worth more than what you paid for it, the next, less.

Example
You feel Happy Donuts Company (HDC) is poised for tremendous growth. They make delicious donuts and the company seems to have a strong and stable management team. HDC stock is currently $5 per share. You buy one hundred shares, costing you $500.

Scenario A: Your instinct is correct! The next time you check the price of your stock, it is being offered at $7 per share. Your $500 investment is now worth $700 – a two hundred dollar increase! You can either sell your shares and walk away with the profit, or, if you think it will increase even further, hold on to them.

Scenario B: Scandal rocks HDC – the president was caught embezzling millions of dollars and is now facing prison time. The stock price plummets to $1 a share. Your $500 investment is now worth $100. You can either sell your shares and at least recoup a hundred dollars, or, if you think the company will eventually recover, keep them.

Bonds
What they are: A bond is a loan to a company or government, with you as the bondholder being the lender. Organizations issue bonds when they want to raise funds. In exchange for the loan, interest (called the coupon) is promised. There are investment grade bonds (low risk, low coupon) and junk bonds (high risk, high coupon). Maturity time frames (the date you get your initial investment back) vary from one to thirty years, depending on the issuer.

As bonds are frequently bought and sold before they mature, investing in them can be very complex. Most beginning investors will stick to the "buy and hold" method.

Why have them: Bonds are considered a fixed income investment, and so compliment the more volatile nature of many stocks. As a general rule, when the stock market performs poorly, bonds do well. And in the event of bankruptcy, bondholders are paid in full before stockholders. There are also tax advantages to some bonds, such as those issued by municipalities ("muni" bonds), where gains are not subject to federal income tax.

Example
Scenario A: The city of San Francisco issues bonds to raise funds to paint the Golden Gate Bridge blue. You think this is a fine idea, so purchase a $5000 bond with a maturity date of three years and a four percent coupon. Every six months you receive $100. Three years go by, the bridge is blue, and you redeem your $5000 investment.

Scenario B: ABC Pharmaceuticals has just discovered a potential new cancer treatment. Needing money for the final stage of research, they issue ten-year bonds. The coupon is twelve percent. You buy a $1000 bond. Unfortunately, another company gains FDA approval for their cancer drug first, causing ABC to go bankrupt. Because you are a bondholder, you receive your $1000 investment back, but not the promised interest rate.

Cash
What it is: In a portfolio, cash (called "cash equivalents") is comprised of several types of low interest, low risk investment vehicles. These include Treasury Bills, certificates of deposits (CDs), money market accounts, and money market funds. Though considered safe, the low return means interest may not keep up with inflation.

Why have them: Having a portion of your savings in cash is a security measure. Not suitable for long-term growth, they are used to offset the risk of stocks and bonds.

Example
Scenario A: Not wanting to tie up your money for longer than a year, but seeking an investment that will be exempt from state and local taxes, you buy Treasury Bills. They are short-term (one year or less) bonds that are guaranteed by the U.S. government.

Scenario B: Looking for the safest investment with the best interest rate, you purchase a CD – three months to six-year loans to financial institutions. The longer the CD, the higher the interest. Though FDIC insured, early withdrawals are subject to penalties.

Scenario C: Seeking liquidity as well as safety, you put some of your capital into a money market account. It is FDIC insured and withdrawals are penalty free. Similar to a savings account, it has slightly higher interest rates but fewer allowed transactions.

Scenario D: Wanting liquidity but better return then a money market account, you invest in a money market fund. You can choose the taxable, but higher interest funds that invest in corporate and government debt, or tax free but lower interest funds that invest in municipal debt. Though not FDIC insured, your withdrawals are penalty free, as long as they are for a minimum amount.