What stocks and bonds are

Investing sounds abstract. Most of it comes down to two deals. You own part of something, or you lend money to someone.

A stock is a slice of a company

A company can be split into millions of equal pieces called shares. Buy one and you own a sliver of the business, including its buildings, its profits, and its future. If a company has 10 million shares and you hold 100, you own one hundred-thousandth of it.

Your share can make you money in two ways. Some companies pay part of their profits to shareholders as dividends. And if the business grows more profitable, other people will pay more to own a piece of it. Over many years, share prices tend to follow profits. Over a few months, they follow mood.

Nobody promises you anything. If the company struggles, the price falls. If it goes bust, shareholders are paid last, after lenders and suppliers, and often get nothing.

A bond is a loan

Buy a bond and you're lending money to a government or a company. They agree to pay interest on a schedule and return your money on a set date. A $1,000 ten-year bond paying 4% gives you $40 a year for ten years, then your $1,000 back.

Move to year 10 to separate the last interest payment from the returned principal. Change the coupon to see which payments change.

Bonds are calmer than stocks because the payments are spelled out in advance. Calm isn't the same as safe. The borrower can fail to pay. And when interest rates rise, older bonds that pay less become less attractive, so their prices drop. In 2022, as rates climbed fast, many high-quality bond funds lost more than 10%, one of their worst years on record.

Why anyone owns stocks at all

Stocks swing much more than bonds, so investors only hold them if they expect a bigger reward. Over long periods, that reward has shown up. Studies of markets in many countries since 1900 put the average return on stocks at roughly 5% a year after inflation, and government bonds at a little under 2%.

Averages hide a lot. Some countries did much better than 5%. In a few, like Russia after 1917, stock investors lost everything. And there have been stretches of ten years or more when stocks did worse than bonds. The higher expected return is real, and it comes with long, uncomfortable waits.

Mixing the two

Many investors hold both. Stocks do most of the growing. Bonds steady the ride, and when stocks crash they give you something that hasn't crashed to spend from. A common pattern is more stocks when you're young and the money won't be touched for decades, then more bonds as the day you need it gets closer.

Most people don't buy single stocks or bonds directly. They buy funds, which pool money from many investors and hold hundreds or thousands of stocks or bonds at once. Which kind of fund turns out to matter a lot, and that's the next lesson.