Stocks and bonds

If investing has a base layer, this is it. Stocks and bonds are the two foundational asset classes that have funded most of the modern economy for over a century. Understanding what they are, and how they differ, is the difference between guessing and reasoning when you put money to work.

Stocks: owning a piece of the company

A stock (also called a share or equity) is exactly what it sounds like: a small slice of ownership in a company. When you buy one share of Apple, you own roughly one fifteen-billionth of Apple. You are entitled to a proportional share of its profits, its assets if it ever gets sold off, and the right to vote on big decisions.

In practice, most retail investors care about one thing: the share price. If the company does well, makes money, and grows, more people want to own a piece of it, so the price goes up. If the company stumbles, fewer people want it, and the price drops.

Some companies also pay dividends, which is a portion of profits sent to shareholders in cash, usually quarterly. Mature, slow-growing companies (think utilities, banks, oil majors) tend to pay dividends. Younger growth companies usually reinvest everything back into the business.

Bonds: lending money for a fee

A bond is a loan. When you buy a bond, you are not becoming an owner of anything. You are lending money to whoever issued the bond (a government, a corporation, sometimes a city). In return, the issuer promises to pay you a fixed interest rate for some number of years, then return your original money at the end.

Example: you buy a 10-year US Treasury bond for $1,000 with a 4% coupon. The US government pays you $40 a year for ten years, then gives you your $1,000 back. Total: $1,400 if everything goes to plan.

Bonds are considered safer than stocks because the cash flows are contractual. The issuer legally owes you those payments. The catch is that if interest rates rise after you buy, your bond becomes less attractive (newer bonds offer better rates), and its market price falls. And if the issuer goes bankrupt, you might not get paid back.

The trade-off: risk vs. return

This is the heart of the stocks-vs-bonds question. Over long periods, stocks have returned roughly 7 to 10 percent per year on average. Bonds have returned roughly 3 to 5 percent. Stocks win on long-run returns by a meaningful margin.

But stocks come with much higher volatility. In any single year, stocks can be down 30 percent or more. Bonds rarely move that much. The price of higher long-run returns is a much rougher ride along the way.

There is no "right" mix. What works depends on how long until you need the money and how much short-term loss you can stomach without panicking. Someone 25 years old saving for retirement can ride out crashes; someone 65 retiring next year cannot.

The classic 60/40 portfolio

For decades, the default "balanced" portfolio for ordinary investors was 60% stocks, 40% bonds. The idea: stocks drive long-term growth, bonds provide stability and income, and the two often move in opposite directions, so when one zigs, the other zags.

This worked beautifully for most of the past 40 years. It worked less well in 2022, when stocks and bonds fell together as central banks raised rates. Diversification can fail in unusual environments. We will dig into that more in a later lesson.

How most people actually buy them

Almost no one buys individual stocks and bonds anymore. Most people buy index funds (or ETFs), which hold hundreds or thousands of stocks (or bonds) at once. One purchase, instant diversification, very low fees. We will get to index funds in a later lesson.

But the underlying reality is the same. When you buy an S&P 500 index fund, you own a tiny slice of 500 companies. When you buy a bond fund, you are lending money to a basket of issuers. Indexing is just a more efficient delivery mechanism for the same two underlying things.