Stocks, Bonds, and Mutual Funds: Videos & Practice Problems

Understanding the distinction between stocks and bonds is crucial for any investor. Stocks represent a stake in a company, granting shareholders partial ownership. This ownership entitles them to a share of the corporation's profits, although companies typically do not distribute all profits to shareholders. Instead, they retain a portion of these profits as retained earnings, which are reinvested into the business to fund future projects and growth.

Investors can earn money from stocks in two primary ways: through dividends and capital gains. Dividends are payments made by corporations to their shareholders, representing a portion of the profits that the company decides to distribute. For instance, if a company earns a profit but chooses to retain some for reinvestment, it may still distribute a portion as dividends to reward its investors.

Capital gains occur when the value of a stock increases. For example, if an investor purchases a stock for $5 and later sells it for $15, the profit made from this transaction is considered a capital gain. This appreciation in stock value is a key reason why investors buy stocks, as they anticipate that the price will rise over time.

Another significant difference between stocks and bonds is the concept of a maturity date. Bonds have a specified maturity date, meaning the principal amount is repaid to the investor after a set period, along with interest earned during that time. In contrast, stocks do not have a maturity date; they are expected to remain in circulation indefinitely as long as the company continues to operate. This lack of a maturity date means that investors do not expect to receive their principal back, but rather rely on dividends and capital gains for returns on their investment.

Mutual funds serve as a convenient investment vehicle, allowing individuals to invest in a diverse array of assets without needing to purchase each one directly. By buying shares in a mutual fund, investors gain exposure to a broad portfolio that may include stocks, bonds, and other securities. This structure functions similarly to a financial intermediary, where the mutual fund collects cash from investors (households) and uses it to purchase securities from various firms.

One of the primary advantages of mutual funds is diversification, which is the practice of spreading investments across a variety of assets to reduce risk. The concept of diversification can be likened to the adage "don't put all your eggs in one basket." By investing in a mutual fund, individuals can mitigate the impact of a poor-performing investment, as their risk is distributed among multiple assets. This strategy is essential for managing investment risk effectively.

Mutual funds can be categorized into two main types based on their management style: actively managed and passively managed funds. Actively managed funds employ portfolio managers who continuously buy and sell stocks in an attempt to outperform the market. In contrast, passively managed funds track a specific stock index, such as the S&P 500, and maintain a consistent portfolio that mirrors the index's composition. This passive approach also provides diversification, as investors hold a variety of stocks within the index.

In summary, mutual funds offer a practical solution for investors seeking diversification and risk management. By pooling resources and investing in a range of securities, mutual funds enable households to participate in the financial markets with reduced exposure to individual asset volatility.