This post is going to be a response to a reader's comment. The reader, Rachel, asked,
"I may sound dumb, but what's the difference between stocks, bonds, mutual funds, and CD's?"
Rachel, that's not a stupid question at all.
A stock is ownership in a company. When a company, or a business wants to expand, it may or may not need to raise money. If the company has taken on a lot of bank debt (i.e. business loans) already in order to grow, it may be looking for other sources of capital. When it wants to raise money from the investing public - you and I - it "goes public". You may have heard this term before. You may have also heard the term "IPO" or initial public offering. When a company sells a piece of itself to public investors, it issues stock to these investors, and a company "IPO" 's .
These investors in turn have the right to a portion of the company's earnings. Depending on how many shares (a share is a single entity of stock) an investor owns, he or she may have a substantial voice in who the CEO, CFO, and board of directors are.
There are many determinants behind a stock price's ascent and decline, but the profitability or how much the company makes after paying its expenses, is one of the primary ones.
A bond is another way that a company raises money. Bonds are also sold to the investing public (aka the common Jane and Joe Blows), but sometimes, they are only sold to private investors (aka wealthy people, endowments at elite institutions like Harvard, and huge pension funds).
A bond is called a 'debt instrument' because when we buy bonds, we, the investors, lend a company money for a specific amount of time - say 2, 5, 10, or 20 years. During this time that the company has our money, it pays us interest - a certain amount of money based on the initial amount that we lent out.
The likelihood that we as investors will be the initial amount that we lent, the principal, determines the interest rate paid on the bonds by the company. The more likely we'll be paid, the less risk there is, so the less interest paid. The less likely we'll be paid, the more risk there is, and thus the higher rate of interest paid on higher risk bonds.
Bonds have credit ratings, which denote how likely or unlikely the principal is to be repaid in addition to all of the interest payments. The rating system is not unlike the American grading system. They are a little more nuanced than I a making them seem, but for all practical purposes, a rating of C is worse than B which is worse than the best, A.
Mutual funds are similar to stocks, but not exactly like them. Mutual funds are companies that have managers who buy stocks or bonds for investors. So a mutual fund can be thought of as a basket of stocks. Some people argue that buying mutual funds is less risky than owning individual stocks because there's less chance that one company could blow up and ruin your savings/stock portfolio. But buying a mutual fund with a manager that's a horrible stock picker, like most mutual fund managers are, is as dangerous, if not moreso, than picking your own stocks poorly.
Lastly, a CD or a certificate of deposit is a savings vehicle that tyour bank provides. It pays a higher rate of interest than your regular checking account, but it's more liquid than stocks or bonds, meaning that it's very easy to gain access to it.
I hope this post was informative and please let me know if you have any questions. Thanks for reading.