How Do Common Stocks and Bonds Differ?

Most individuals have mutual funds in their retirements, whether it is a 401K or IRA account. Within these retirement accounts, the portfolio manager for the mutual fund has probably bought a few hundred common stocks and bonds if it is a balanced mutual fund (balance of stocks and bond with a mutual fund). But, you should know the difference between a common stock and bond, even if you never plan to own an individual stock or bond. But, let us say that you have decided to purchase a stock or bond; the information listed below should provide you with a better understanding of the investment instruments.

Understanding an Individual Common Stock

The purchase of common stock represents ownership in a company. People who own individual stocks are commonly referred to as shareholders of the company. If the common stock is of a publicly traded company, like Microsoft, then you, as a shareholder, will usually have voting rights as a company owner. Unfortunately, if you own a mutual fund that contains individual common stocks, you will not be considered a company owner; therefore, you will have no voting rights because the mutual fund company is the owner of those shares of stock.

The value of the stock increases or decreases based on the supply and demand of the individual common stock. When a company shows strong earnings or the future earnings appear to be bright, more people are likely to demand the stock. In many cases, this will drive the price of the stock higher. On the other hand, if a company misses its earning estimates or its corporate executives have engaged in illegal activities, it is not uncommon to watch the price of the stock fall, as the demand for the stock decreases. However, in most cases, investors of an individual stock desire for the stock price to go up.

A stock company also can reward an investor by offering a dividend, which is paid on a per share basis. The company can declare a dividend for investors of record on a specific date; for example, you must own the stock on January 3, 2008, in order to receive the $2.00 per share dividend. Keep in mind, companies are not required to pay dividends, and many of the common stocks that trade daily do not.

Understanding an Individual Bond

An individual that purchases a bond is not an owner of the company, but is a debtor. As a bondholder, you have lent money to the borrower, for a specific period of a time, with the expectation of the entity paying you interest when due and your principal at maturity. The company, government or other entity is obligated to pay the bondholder; otherwise, the entity is considered to be in default.

When the bond matures, you will receive the face amount of the bond. In addition, many bonds pay interest to their bondholders on a bi-annual basis. The amount of interest the bondholder receives on a yearly basis is based on the bond’s face amount multiplied by the bond’s stated interest, which is commonly referred as the coupon rate. For example, exactly one year ago, you bought a bond with a $1000 face amount and 6% coupon rate. Twice a year, the bond issuer will send you a check for $30 ($1000 x ½ 6% = $30 twice a year) until the bond matures.

As a bondholder, you usually have the right to sell the bond in the secondary market. Sometimes, interest rates begin to fall, and when they fall, the price of bonds usually rises. When the price of the bond is higher than its face amount, the bond is said to be trading at a premium, or above par value. In some cases, bond investors will sell their bond in the secondary market if the price of the bond is higher than its face amount; however the bond’s years to maturity and its coupon rate need to be considered.

Summary of Stocks

1. Common stockholders - owners of the company

2. Hope the price of the stock appreciates in value; look for good corporate news

3. Some companies pay dividends, usually in the form of cash – taxable in the year distributed

4. Dividends are not mandatory

5. Common stocks have no maturity date

6. The stockholder will realize a capital gain or loss when the stock is sold, in most cases

Summary of Bonds

1. Bondholders have lent the corporation, government, or entity a sum of money

2. The bond will eventually mature

3. In the meantime, the bondholder usually receives an interest payment on a bi-annual basis

4. Some bondholders want interest to drop in order to sell their current bonds at a profit

5. If a company folds, bondholders must be paid before common stockholders

6. If there are bonds within a mutual fund, your mutual fund company will be considered to be the bondholder