All About Stocks and Bonds

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Stocks
When you own a company’s stock, you own part of that company. If it does well, your stock will do well. You can buy and sell whenever you want through your broker or self-serve sites like ETrade or Datek.

Advantages: You can beat the market if your stock is good; if your stock is excellent, you can really beat the market. You can pick the stock in an industry you understand. Also, your money is liquid, meaning you can access it at any time by selling your stock.

Disadvantages: Unfortunately, if a company does poorly, so does your stock. Because a stock isn’t diversified, that can mean disaster for you (although you can easily reduce your risk by picking bigger, solid companies). Also, most people are not good at picking excellent stocks. In fact, they think they are but they really aren’t (more about investor psychology).

Inevitably, when I’m teaching the basics of stocks, someone will pipe up and say, “So what stock should I buy?” Let’s go through it.

The simplest way to narrow the universe of stocks is to think of companies you like and use. What are 15 companies you use and return to time after time? Think of everything, including food, clothing, services, technology, entertainment, transportation, etc. There, you just went from 5,000 stocks to 15.

A good company isn’t necessarily a good stock! Let’s think of clothing for a second. What are your favorite places to shop? Abercrombie? Guess? Gap? Ok, take Gap. Let’s do a very simple analysis of Gap as a company. It has good clothes that are consistent and stable: Khakis, white shirts, polos, jeans, things that don’t go out of style. They appeal to men and women. They have a lot of locations and some great advertising. Hell, I shop there. Unfortunately, good products don’t always make a good stock: Here’s Yahoo’s 5-year stock performance. In this 5-year period, they dropped from a high of around 52 to a low around 8. “But Ramit,” you might say, “the entire economy was in a recession.” Yeah, but Gap also severely underperformed the market during this time.

The point is that you need a deeper analysis than “I think their khakis are pretty.” For that, you need to know:

Trends. Are sales increasing from this time last year? 2 years ago? 5 years ago?
Products. Is the future bright in terms of upcoming product development?
Revenues, profits, growth, earnings per share. The real financial nuts and bolts of a stock, these are intimidating at first. Luckily, many sites will guide you though it.
Insider trading. Are senior executives at the company buying more stocks (indicating they have confidence in the company) or selling?
Management. Is management good? What is the turnover? What is their philosophy and ability to execute?

You can get all of this information online for free. Here are some great sites to start you out.

The MSN Research Wizard will help you analyze a stock step-by-step.

Yahoo Finance lets you view the standard details about any stock.

The Motley Fool is great for first-time investors.

Once you start looking at charts, earnings, balance sheets, etc, you’ll start to get a good sense of what’s going on. It just takes practice.


Bonds
Bonds are IOUs, like CDs (certificates of deposit). If you buy a 1-year bond, the bank says “Hey, if you lend me $100, we’ll give you $102 back in a year.” The approximate current rate of return for a 2-year bond is 2.89%.

Advantages: You know exactly how much you’ll get when you invest in a bond. You can choose the amount of time you want a bond for (1 year, 2 years, 5 years, etc). Longer time periods yield you higher return rates. Also, bonds are extremely stable, especially government bonds. The only way you’d lose money on a government bond is if the government defaulted on its loans–and it doesn’t do that, it just prints more money.

Disadvantages: Unfortunately, bonds have significant disadvantages. Because they’re so stable (lower risk), the reward on an excellent bond is dramatically less than an excellent stock. Investing in a bond also renders your money illiquid, meaning it’s locked away and inaccessible for a period of time. That’s usually bad.

With these qualities, what kind of person would invest in bonds? Let’s see…extremely stable, essentially guaranteed rate of return, but relatively small returns…who would it be?

If you said “me” and you are in your twenties, I want to punch you.

Actually, it’s old people and rich people who find bonds most attractive. Old people need to know exactly how much money they’re getting next month for their medication or whatever old people do; they can’t stand the volatility of the stock market because they generally don’t have much other income to support themselves. Rich people, on the other hand, have naturally become conservative with so much money. Put it this way: When you have $10,000, you want to invest aggressively to grow. When you have $10 million, you want to conserve. So a guaranteed bond at 2% or 3% is attractive–and 3% of $10 million is $300,000 anyway.

Now you see why bonds are exactly the wrong investment for most young people. Also, with a longer investment outlook, you can invest more aggressively to get much higher returns than bonds.

Now what?

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19 Comments

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  1. Quick question about bonds– my mother is in her late 50s and has almost nothing saved for retirement. Believe me, I know how depressing that sounds.

    Is it worth her while to buy some bonds, or is it pretty much not going to do any good this late in the game? Please note that we’re not exactly talking about thousands of dollars here.

    Thanks!

  2. Bonds usually have 5-7% return, more return the riskier the bond is. I’d suggest you get a CD or the best is to put the money in the online savings account. HSBC gives 5.05% on savings and your mom can use any HSBC ATM to withdraw money anytime.

  3. You didn’t mention that the rich invest in government bonds because the returns are tax free. That is a significant advantage when you are in the highest tax bracket.

  4. Another great on-line savings account is emigrantdirect.com. It’s paying 5.15%.

  5. Government bonds are NOT for the most part tax free, not from the Feds they’re not (from state tax they are, mostly)….Municipal bonds are free from federal income tax….

  6. I’m a middleaged man who is full of admiration for the quality of the advise on your site.

    Who said that ‘you can’t put an old haed on young shoulders. It has taken me many years to learn what you already know. I also share your views on Real Estate. If people really need ‘bricks and morter’ they could consider researching large property trusts, Like (Westfield or Lead Lease on the ASX)
    Congratulations on a wonderful site.

  7. Which one would be the most appropriate, for a younger like myself at the age of 20, either stocks, bonds or CDs.

  8. I know why stocks fluctuate in prices, but who has the authority to set the price?

  9. Hello there,

    I’m playing a free version of the Stock Market Game on my school computers. We’re not doing so well because we failed to find descent stocks. Are there any stocks that you personally love or enjoy using every now and then? If so, please share the ticker symbol with us.

    Thank you in Advance

    ~Nikita, Andrew, Billy

  10. How long do you think I would sell my stock if ever I bought some…By the way, I am studying this very interesting field of earning money…I m in my mid-30s Id like to invest..though, I dont have that big money…Do u think is it possible even I dont have the big bucks to invest in Stocks?

  11. Hi. I am a college student and i am doing a project that consists of investing 1,000,000 dollars for a company over 5 years. What do you think i should lean towards, stocks or bonds?

  12. How much money do u need to get started?

  13. Your advice/statements/comments show your lack of experience.

  14. I’ll have to disagree about your reasoning on bonds for those in their 20′s. Assuming that most will be saving to buy a house in their 30′s, you would want a stable source of income (so you can withdraw it anytime) for the downpayment on the house, which will probably consume the savings of most (except your friends who make six-figures).

  15. Hi- My husband and I are looking to invest some money into stocks and we are extremely new to this, so I was wondering what the minimum stock purchase would be.

  16. What ever happened to using bonds as a smart way for diversification??? I believe it was John Bogle who said that you should invest x percent of your assets in bonds, where x is your current age. Are you contradicting Mr Bogle?

  17. thank you for this site it gives a lot of insight into the world of stocks. i am in the tenth grade and doing research and i just wanted to let you know how much it helped and how much i appreciated it. thank you again

  18. please i want to know the criterion to be considered before buying stock, in a company

  19. I am in my early 30′s and want to invest for a retirement. However, I am not exactly sure where to begin or what to invest in. I don’t have a lot of money at all and basically live paycheck to paycheck. I am raising 2 kids, so I want to start out with something kind of small and then gradually put more and more in. Do you have any suggestions? I would greatly appreciate any help.