What are stocks, bonds, and cash?
Stocks - A company sells shares of its stock as one way to raise capital to fund the growth of its business. When you buy a stock, you become a part owner in the company that has issued the stock. A share of stock represents a claim on the investments and earnings of a corporation. Investors in stocks generally are interested in having their stocks appreciate in value, rather than provide current income.
Determining the value of a company’s stock is a complex process. Generally, the value and price of a company’s stock are based on its outlook for earnings, the market value of assets on its balance sheet, and investors’ expectations about the company’s future.
Bonds - A bond is basically an IOU from a company or the government. When a company or government needs money, it sells bonds in exchange for the use of your money. The bond issuer typically promises to pay you regular interest payments, known as the bond’s coupon rate. The principal is returned when the bond reaches maturity. Bonds are geared for investors looking for income or for those hoping to preserve what they’ve already invested.
Historically, bonds have helped many investment portfolios stay afloat in sinking stock markets. When one market has been down, the other has often been up.
There are two main types of bonds: those bonds issued by governments and those sold by private corporations. There are different types of government bonds. U.S. Treasury bonds are considered relatively stable. Municipal bonds are dependent on the financial stability of the entity. Corporate bonds are riskier, but they offer potentially higher yields to investors.
Cash Equivalents - Short-term securities such as bank accounts, certificates of deposit and U.S. Treasury bills. These securities are often referred to as cash equivalents. The interest earned on the short-term investments the fund makes is passed along to you, the investor. Because cash-equivalent funds are among the most secure, investors generally use them to help preserve what they’ve invested. The downside of cash equivalents is that they offer no real opportunities for long-term growth.
What should I invest in?
1925-2004 Average annual rates of return
Small Stocks 12.7%
Large Stocks 10.4%
Bonds 5.4%
T-Bills 3.7%
Inflation 3.0%
Clearly, stocks have the highest average return. So why not invest all of your money in stocks? First, past performance cannot guarantee future results. Second, you may not be investing for 25 years. Generally, the shorter the time until you will need to spend your money, the more conservative you should be so that you aren't hurt by a temporary down swing in stock values. Third, stocks are the most risky -- note the extremely wide range possible with stocks. Financial catastrophes have happened in the past, and will happen in the future -- we just don't know when. In the Great Depression, stocks lost about 90% of their value from the peak in 1929 to the bottom in 1932. But the value of many bonds, particularly government bonds, actually went up during the same period.
If it’s growth you want, stocks provide the greatest potential over the long term, but with the greatest volatility. Bonds, on the other hand, can sometimes appreciate in value, but growth is not the primary reason that people invest in them. If preservation of capital and liquidity are your primary objectives, cash equivalents may be the best choice for you. Keep in mind, though, that inflation may outpace the growth of your investments.