Stocks, Bonds, & Mutual Funds…What’s the Difference?

Saving money in stocks, bonds, and mutual funds is essential to a successful retirement strategy. Because social security and pension plans only provide so much, you also have to consider participating in your company’s 401k/403b or an IRA to bolster your retirement. But what you need to understand is that those terms simply describe a set of tax laws, not the investment vehicle itself.

Most 401k/403b and IRAs use stocks, bonds, and mutual funds as the actual investment vehicle to grow your retirement dollars. But do you understand the difference between one and the other? I will attempt to give a brief overview of each. Let me just say upfront that this is just a synopsis, as I’m not trying to cover every detail about either investment vehicle.

Stocks: Selling shares of stock is a common method corporations use to raise capital for things such as expansion and improvements, without borrowing large amounts of money. When you own stock, you actually own part of the company, and the value of your shares goes up and down as the company's perceived market value fluctuates. Stocks are basically certificates of equity and compared to most other types of investments, are considered riskier, but tend to have the greatest potential for long-term gains.

It's important to remember that when stock prices go down, you don't actually lose anything unless you sell the stock while the price is lower than what you paid for it. As long as you hold onto the stock, you can recoup any “paper” losses the next time the stock price rebounds (if it ever does).

Stocks do not have any guarantees of return or safety of principle. That means growth is not promised, and in the end, you may lose everything including your original invested amount. So be careful when choosing stocks for your retirement.

Bonds: Bonds are investment instruments that are basically loans to a company, a municipality, or the federal government with the expectation that the loan will be paid back at a set date in the future. Like all loans, bonds come with an interest component, which can involve periodic payments over the life of the bond or a single payment at maturity.

Bonds can be bought in increments like $1,000, $5,000 or even $10,000. For instance, if you buy a $10,000 bond, you will receive that $10,000 back when the bond matures and in the interim, you will receive interest payments (generally) twice per year. This makes bonds a little different from many other investments. With stocks, you’re looking for capital appreciation. In other words, you want the price of your stock to go up. When you buy a bond you’re not really concerned with the increase or decrease of the bond price, instead, you’re primarily looking to generate regular income in the form of interest.

Interest is the biggest part of a bond—for lending them money, the company or government entity agrees to pay the purchaser a specific rate of interest at predetermined intervals. Their maturities range from short-term (up to 5 years) to intermediate-term (7 to 10 years) to long-term (20 to 30 years). And, those interest rates are typically higher than you’d receive from a savings or CD.

Even with interest rates generally higher than your bank account, bonds should not make up a significant portion of your long-term savings. Compared to other long-term investments like stocks, the interest earned by bonds is quite low. Stocks historically return between 8-11% on average per year (long-term), so investing for your future solely in bonds will probably not yield the best financial results.

On the other hand, bonds are considered safer investments than stocks. This is especially true with federal government bonds, which are backed by the full faith and credit of the U.S. government. In addition, some municipal bonds may even be insured. This makes buying bonds a good way to save money when the market is in turmoil.

Bonds are generally used to offset some of the risk in your portfolio. Stocks can fluctuate greatly from day to day, but bonds tend to remain fairly stable, and don’t forget they also pay out interest. So, by including bonds in your portfolio you can lessen some of the risk you’re taking with stocks by adding some stable income from bonds.

Mutual Funds: Mutual Funds are a way for a group of investors to pool their money so they can invest in a wider variety of stocks and bonds. The group of investors forms a “mutual” investment group and hires a professional fund manager. This manager makes decisions about how to invest the money based on the goals of the group. In a mutual fund, the value of your shares goes up and down as the value of the stocks and bonds in the fund rise and fall.

Unlike stocks, where you’re basically investing in one company, mutual funds may be invested in dozens of companies all at once. This built-in diversification can provide a certain amount of security that stocks do not provide, yet still give you access to similar financial gains.

There are literally hundreds of established mutual funds that have various goals to suit your retirement needs. What makes mutual funds attractive to many people is the fact that In order to really make wise decisions when you buy individual stocks and bonds, you'd have to do extensive research on various types of business sectors (automotive, computer, medical) and on specific companies (GM, Apple, Bristol-Myers). This is work that most of us aren’t interested in or even capable of doing. Because of the fund manager and his or her team, this work has already been done. 

Mutual funds are great for diversifying your investments, and they require as little as $25 to $500 to get started. This means that almost anyone can take advantage of a professionally managed investment account. A good retirement plan will be heavily invested in mutual funds.

Hopefully this gives you a little more insight in the world of securities. And as I’ve always said, get with a financial professional to talk about your specific needs and have them put together a retirement game plan fit for you.