Stocks, Bonds, and Mutual Funds - Online Tutor, Practice Problems & Exam Prep

Stocks represent ownership in a company, allowing shareholders to earn profits through dividends and capital gains, with no maturity date. In contrast, bonds are loans with a fixed repayment schedule. Mutual funds offer diversification by pooling various investments, reducing risk. They can be actively managed, with constant buying and selling, or passively managed, tracking specific indices. This approach helps investors mitigate risk by spreading investments across multiple assets, embodying the principle of not putting all eggs in one basket.

Stock Definitions

So, stock is different from bonds because it represents a stake in the company. You're going to have partial ownership of the company. Whereas when you have a bond, they're going to repay you the principal. They're going to give you that money back that you lent them. You're going to get it back eventually. However, when you own stock, you own ownership in the company. So the shareholders are entitled to a portion of the corporation's profit. Even if you own a very small part of the company, you own that share of the profit. Okay?

However, the company doesn't generally just pay out all their profit just to their shareholders every year. "Oh, we made $1,000,000; here's the $1,000,000 we made." No, it keeps some of it as what we call retained earnings. You've taken an accounting class, I'm sure retained earnings was mentioned all throughout that class. Retained earnings, we love to talk about that. So retained earnings are used to fund future projects, right? If you made some profit this year, but you don't pay it out to your investors, well, you retained it to help you grow the business, right?

However, when you make an investment, there are two ways that you make money by buying stock. First, you get dividends, and these are payments by the corporations to its shareholders, and this is payments of profit, right? They're going to take some of that profit and they're going to distribute it to the shareholders because they've earned some profit and they're not going to retain it all; they give some of it back as dividends. The other way you make money is through capital gains. So that's the idea that there's going to be an increase in the value of the stock. So if you bought the stock, say, buy for $5, the stock, and you sell it for $15, man, you're a savvy investor there. Right? You bought it for $5. Let me make that fit on the screen there. Oops. What a savvy investor. You bought it for $5, sold it for $15. Well, those are capital gains, right? The change in the price of the stock. So those are the two ways that you make money. You either get dividends, or you get capital gains from stock.

Now, the difference with stock from bonds is this idea of a maturity date. Stocks do not have a maturity date. So when you buy a bond, it says, okay, in five years, I'm going to repay you the principal. You bought a $1,000 bond, well, you're going to earn interest throughout those five years, and then in five years, you're going to get that $1,000 back. However, with stock, there's no maturity date, right? We expect these companies to keep on going, or why would we invest in them? If we think they're going to go bankrupt, it wouldn't be a good investment, right? Corporations are assumed to continue indefinitely, so there's no maturity date. You're not expecting to get that principal back. So that's where the money comes from: the dividends and the capital gains, the appreciation of the value of the stock. Cool? Alright. Let's pause real quick and we'll discuss mutual funds in the next session.

Mutual Fund Definitions

All right, so mutual funds are kind of like a grab bag of other investments. Instead of buying shares of this company, shares of that company, shares of this company C, shares of company D, you can just buy shares of a mutual fund and that already owns a broad range of investments. Okay? Mutual funds can own stocks, they can own bonds, they can own all sorts of different investments, alright? So when you buy shares in a mutual fund, if you buy shares of a mutual fund that owns Apple, well, you didn't buy shares of Apple. You bought shares of the mutual fund. Okay? So the idea here is that we're going to have the firms over here similar to a financial intermediary. We're going to have the firms over here. We're going to have the mutual fund in the middle, and then we'll have, the investors over here. Well, we'll say the households. HH, the households that are buying from the firms. So here, the mutual funds are going to buy the securities of the firms. They'll buy stocks and bonds from the firms and they'll give cash to the firms. The firms will get back cash, and now the households will buy shares of the mutual fund. So they'll buy mutual fund shares instead of shares of the investments directly of the firms, they buy shares of the mutual fund for cash. Right? So that's going to help facilitate that money to the firms.

Now why would a household buy these mutual funds? It's the idea of diversification. So we'll get to that in a second. So, one thing before we get to diversification, let's discuss how these funds are managed. The first one is an actively managed fund. Well, they just have a portfolio manager that's constantly buying and selling stocks, right? Constantly buying and selling stocks. That makes sense, right? Actively managed, well, they're actively buying and selling stock. Think about a passively managed. Well, they're just going to follow a specific stock index and hold more constant portfolios. They're just going to, let's say, follow the S & P, and they're just going to buy the same stocks that are in that index and just hold them. And now you're diversified because you own this stock index. So, that idea of diversification, it's the idea of reducing risk by replacing a single large risk with smaller unrelated risks, right? It's the idea of don't place all your eggs in one basket, right? Let's carry 6 different baskets with one egg in each basket. That way, if we drop a basket, we only lose one egg instead of all six eggs. Cool? So that's the idea of diversification. It helps you reduce risk by owning small bits of a whole bunch of different things. Cool and that's what a mutual fund helps you do. Alright. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the difference between stocks and bonds?

Stocks represent ownership in a company, giving shareholders a claim on part of the company's profits through dividends and capital gains. Bonds, on the other hand, are loans made to a company or government, which promise to repay the principal along with interest by a specified maturity date. Stocks do not have a maturity date, while bonds do. Stocks offer potential for higher returns but come with higher risk, whereas bonds are generally considered safer but offer lower returns.

How do mutual funds work?

Mutual funds pool money from multiple investors to buy a diversified portfolio of stocks, bonds, or other securities. Investors buy shares of the mutual fund, not the individual securities. This diversification helps reduce risk by spreading investments across various assets. Mutual funds can be actively managed, with a portfolio manager making frequent trades, or passively managed, tracking a specific index. This approach allows investors to benefit from professional management and diversification without needing to buy individual securities themselves.

What are the benefits of investing in mutual funds?

Investing in mutual funds offers several benefits, including diversification, professional management, and ease of access. Diversification reduces risk by spreading investments across various assets. Professional managers handle the buying and selling of securities, saving investors time and effort. Mutual funds also provide liquidity, allowing investors to buy and sell shares easily. Additionally, they offer a range of investment options, from conservative bond funds to aggressive stock funds, catering to different risk tolerances and investment goals.

What are dividends and capital gains in stock investments?

Dividends are payments made by a corporation to its shareholders from its profits. They provide a regular income stream to investors. Capital gains occur when the value of a stock increases, allowing investors to sell the stock at a higher price than they paid. For example, if you buy a stock for $5 and sell it for $15, the $10 difference is your capital gain. Both dividends and capital gains are ways investors can earn money from stock investments.

What is the difference between actively managed and passively managed mutual funds?

Actively managed mutual funds have a portfolio manager who makes frequent trades to try to outperform the market. This involves buying and selling stocks based on research and market analysis. Passively managed mutual funds, on the other hand, aim to replicate the performance of a specific index, such as the S&P 500, by holding the same stocks in the same proportions as the index. Actively managed funds typically have higher fees due to the active trading, while passively managed funds usually have lower fees and are considered more cost-effective.