The Markets Made Simple

    A Closer Look at Stocks and Bonds

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    We want our kids to be financially literate, but it can be hard when adults can’t quite find the right words to explain some financial topics. Let’s face it, the industry is somewhat known for its abbreviations (IRA, HSA, TUWs) and references to obscure IRS tax code (401(k), 403(b), etc.). That’s why I’m sharing some basic financial literacy you can pass along to your kids.

    First, this warning: Be prepared for a look of pure elation followed by disappointment on your child’s face. When we were discussing the question, What is a stock? at dinner the other night, my oldest assumed that if he bought a stock, that meant he owned 1 percent of the company. He started dreaming of owning 1 percent of Target and practically swimming in beef jerky and gum. I had to reel him back to reality. (Disclosure: This is not an endorsement of Target and should not be considered investment advice.)

    Here’s the quick primer: Stocks are ownership interests in a company. Owning a share of XYZ corporation means you own a small bit of XYZ corporation. A really, really small bit. If XYZ corporation is successful, then typically your stock will increase in price. On the other hand, if XYZ corporation hits hard times, your share price will probably fall as the value of the company (and its earnings) falls.

    When we invest in stocks, sometimes known as equities, we need to be prepared for a bumpy ride. Sometimes really bumpy. Stocks go up and they go down, often in the same day. Over time, we expect that the stock market as a whole will go up as businesses earn more money. However, that doesn’t mean all stocks – including yours – will increase in value over time. According to a recent article from marketwatch.com, an individual stock is just as likely to go down over time as it is to go up. In reality, much of the U.S. Stock Market’s historical, long-term, positive performance is due to the stock of a relatively small number of businesses performing really, really well.

    Let’s talk about another popular investment vehicle – bonds. Bonds, also known as fixed income, can provide investors with income in the form of interest payments and, ideally, principal protection. Principal protection means you have high expectations of getting all of the money you invest back. Financial advisors will tell you bond markets are generally less volatile than stock markets.

    What you might tell your kids: Think of bonds as loans. If you own a bond or bond mutual fund, you are actually the lender. The bond issuer is the borrower. When you buy a bond, you loan money to the bond issuer and they pay you interest on the loan. Businesses, the Federal Government, states, counties, and foreign governments can all issue bonds.

    Ready for more details? Let’s say you purchase $10,000 of a bond issuance. That $10,000 is considered your principal. The principal is your initial investment that you loan to the bond issuer. In return, the bond issuer (remember, the bond issuer is the borrower) pays you money each month in the form of interest, sometimes called a coupon payment. Then, when the bond matures, the loan is due. The bond issuer repays you your principal, and you don’t receive any more interest payments. Technically, there is some nuance around the face value of a bond versus what you actually paid for it. You could purchase a bond at a premium (higher than face value) or at a discount (lower than face value), but when the bond matures, you get the face value of the bond regardless of what you paid for it.

    Typically, the longer your bond takes to mature, the higher the interest you earn. More interest is not always a good thing. The reason why you are getting paid more money for a bond that has a longer maturity date is because there is presumed to be a higher risk of the bond issuer defaulting on the loan. If a bond issuer defaults on its loan (your bond), you may not get your principal back.

    In the bond world, it is important to remember that you generally only get higher yields when you are taking on more risk. Some of these risks include credit quality (How junky or high-yield are your bonds? How likely are you to get your money back?), maturity (the longer the length of time it takes to pay you back, the greater the risk something goes wrong), and interest rate risk (when interest rates rise, bond prices typically drop).

    Some people think it’s not possible to lose money on bonds. Those people are wrong. However, the magnitude of loss on investment grade bonds compared to stocks is typically much lower. This is also why we don’t expect to earn as high of a return on bonds as we do when we invest in stocks.

    I hope you will share this information with your children. These quick conversations about finance and money can really add up to an important education for kids and their parents. Next month, I’ll address funds – mutual funds versus exchange-traded funds, and other fund stuff! In the meantime, challenge yourself to talk about investing with your kids at dinner tonight, and let me know how it goes.