Your portfolio is made up of assets. An asset is a tool used to make more money. Companies use assets like plants so they can produce widgets, land so they can raise crops, and wood, glass and marble so they can build hotels. You can also hold paper investments in your portfolio. They are not tangible, like land, but they can work to make more money.
Common investment assets include patents, real estate, stocks, bonds and derivatives. We’re going to focus on the paper investments but a diverse portfolio will include more than just paper investments.
Intro to the Markets
There are five major asset classes that most investors begin with when they first start investing. They are Stocks, Bonds, Options, Futures, and Forex.
Stocks and Bonds
A stock is a piece of ownership or a claim to future earnings for a business. When a company decides to expand operations or they find themselves in need of cash for their business, they have two basic ways of raising cash. They can issue stock or sell bonds. A bond is similar to a stock in that it is a claim to a portion of earnings but the rules, to how those earnings will be paid, are what distinguish a stock from a bond.
A stock is also commonly called equity. When you buy stock or equity in a company you become a stockholder and you are buying a piece of the future success or failure of that company. You become a part owner with the rest of the stockholders. A stock is also called a share, because you are sharing ownership. You have the right to vote on company decisions by either selling the stock if you disagree with their decisions or buying more shares if you agree. You also are given the right to vote on the management, the group of people that will oversee the company, but the details on how much voting power you have will differ from company to company. If the company has a great year or quarter and the stock price rises then you, as the stock holder will see an increase in your overall equity. However, if the company continually makes bad decisions you will see the earnings in your portfolio shrink.
A bond is a claim to a specific stream of income. A bondholder does not have the right to vote on company decisions the same way a shareholder does. They may decide to sell their bond but this will have little to no effect on the company. A bond is more like a contract. Some bond contracts include a periodic interest payment to the bondholder as long as they hold the bond and until the lump sum is paid back. These are called coupon bonds. Other bonds do not pay a periodic interest payment during the life of the bond and these are called zero-coupon bonds.
If the company has a great year and their stock price increases, the bond holder does not see any extra income because they are not a part owner of future earnings. They are only entitled to the specific stream of income that they were locked into when they purchased the bond. However, the bond holder is protected on the downside better than a stockholder would be if the company began to lose money. The stock price would see a drop, but the income stream from the bond would still stay the same, as long as the company stays in business.
Do you use stocks and bonds in your portfolio?