Through investments, it is possible to amass hundreds of thousands, if not, millions of dollars in wealth over the long term. As part of the wealth creation process, it is critical that you learn to distinguish between common stocks and bonds. Common stocks and bonds feature distinct risk versus reward profiles, which are due to basic corporate finance structure. With knowledge of this relationship, you can best put together a diversified portfolio of stocks and bonds according to your objectives.
To raise capital, corporations issue bonds and shares of common stock. When you buy bonds, you are actually a creditor, who loans out money to the firm. You would then collect interest payments, until your loan principal is repaid at maturity. When buying shares of common stock, you are exchanging cash for a corporate ownership stake. Bonds are senior securities to shares of common stock. This means that bondholders will receive payments first, from the proceeds of any asset liquidations due to corporate bankruptcy. As a going concern, the corporation is legally mandated to make interest payments on bonds. The corporation, however, pays dividends on stock at its discretion–out of net income.
As an ownership stake, each individual share of common stock carries one vote. Bonds, however, do not feature voting rights. Because of their voting rights, large investors target common stock investments for control purposes. A large investor can effectively control a corporation after purchasing more than 50 percent of its shares of outstanding common stock. From there, the large investor can make an offer for all of the remaining shares of outstanding common stock and purchase the corporation, outright.
Risks Versus Reward
Common stock share prices largely track corporate earnings. As such, prices for common stock shares can swing between zero and infinity over the long term. As a measure for U.S. stock market performance, the S&P 500 Index has averaged an 11 percent annual return since its 1957 inception. This 11 percent mark does include several peaks and valleys, such as 38 percent gains in 1995 alongside 37 percent 2008 losses. Stocks are especially volatile amid recession, when corporate earnings are weak.
For bonds, you can expect to generate less than six percent returns each year. In exchange for these relatively minimal returns, you will be exposed to far less volatility than you would with stocks. Be advised that bonds are more so subject to inflation and interest rate risks. Inflation relates to a rising price level for goods and services, which erodes the purchasing power of future bond interest and principal payments. Interest rate risk occurs when prevailing rates rise. At that point, new bonds offer higher payments than the bonds you already own. Existing bonds in circulation would then lose value and sell for a discount–to compensate investors for relatively minimal interest payments.
A properly diversified portfolio is likely to include both stocks and bonds. As a young twenty-something, however, you may put all of your investment dollars into stocks–to benefit from long term growth. As you age and near retirement, you will increase your exposure to bonds until they make up at least 40 percent of your portfolio. For diversification purposes, you can buy into stock and bond mutual funds. Each mutual fund share features asset claims above a larger pool of dozens of different investment securities.
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