What's the difference between stocks and bonds?

The investment world can often seem complex and overwhelming. Business analysts and news networks tend to use convoluted jargon such as “headwinds,” “dovetail” and “bullish.” Despite the complexities surrounding it, the principles of investing are actually quite simple. Investing can be broken down into a series of basic principles and fundamentals that you can build upon over time. It all begins with setting money aside so it can start working for you and taking advantage of the most important variable — time.

Video transcript

Beginning to invest can be intimidating. Most young adults are confused by financial jargon, don’t know where to start and think such a complex task as investing should be left to the old corporate guys. In reality, there has never been a time easier than now to get started. With a variety of affordable online management services, loads of free information on investing and an increasingly globalized world, you can easily take control of your financial future by starting to invest now.

Two of the most common types of investments are stocks and bonds.

What are stocks?

Let’s start with stocks. When you buy a stock, you’re buying a portion of a company. For example, Kate opens an online organic grocery store. She delivers to four neighbourhoods and is doing really well.

Kate wants to expand the service to deliver everywhere in the city. She needs more trucks, more warehouses and more staff, but she doesn’t have the cash. Kate doesn’t want to borrow the money, so she’s going to sell part of her ownership in the company to other people on the stock market. Kate goes to an investment banker to help her with the initial public offering, or IPO. This is the first time a company’s stock appears on the stock market where investors like you can buy and sell it. Kate’s company is valued at $100,000, so she sells 10% of her company for $10,000 and she issues 100 common shares.

You love organic food, and you see the potential for Kate’s business to grow, so you decide that you want in. You buy one stock for $100, and you now own a very small part of Kate’s organic grocery business. Over the next couple years, Kate is very successful, and her business becomes the most popular organic grocery delivery in the city. It is now worth $200,000. This means the one stock of Kate’s company that you bought is now worth $200, a 100% return. You can now sell the stock for cash or hold onto it in hopes that Kate’s company will grow even bigger.

What are bonds?

Another way to earn money is investing in bonds. Think of a bond as a loan in which you are lending money to a company or government.

Jake owns a construction company building a condominium and needs to raise cash to do so. He can borrow the money in the form of a bond. Suppose the total bond issue is for $200,000, and you decide to buy $20,000 worth of the issue. Jake promises to pay you back in the five years after the condo is built.

In order to make the deal attractive for you, he pays you to lend him the money in the form of interest or a coupon rate of 5%. This means for the next five years, Jake will pay you $1,000 every year and then on top of that, at the end of the five years, he will pay you your $20,000 back. At the end of five years, instead of $20,000, you have $25,000.

Both buying stocks and buying bonds offer different pros and cons. Stocks are typically riskier and offer a higher reward in the long run. Bonds are the opposite and offer a safer investment but a lower reward. Overall, having a diversified portfolio with a wide variety of investments will protect you from too much risk and will allow you to achieve your financial goals.