You’ve heard about stocks, bonds, and mutual funds. Perhaps, however, you aren’t up to speed on what distinguishes these investment vehicles.

Don’t stress! We’ve got a beginner’s guide to all things stocks, bonds, and mutual funds to fuel your interest. Keep reading and we’ll help you make savvy investment choices down the road.

What are stocks?

When you purchase a stock, you effectively buy a tiny piece of whichever company sold the stock. Typically, a company issues a stock offering in order to raise money to fund new projects or expand their operation.

What are the perks of owning stock? First, you own a percentage of the overall value of the company. Second, certain companies pay dividends to their shareholders. 

To buy stocks, you’ll need to open an account with a brokerage firm. Online discount brokerages, such as Robinhood, are all the rage these days. They’re easy to use and don’t charge the exorbitant fees associated with full service brokerages.

Types of stocks

There are two primary types of stocks: common and preferred. Common stocks are the most widely traded. They entitle shareholders to voting rights, while preferred stocks offer higher dividend payments. 

Voting rights grant shareholders the ability to influence certain company decisions, like appointing new board members or approving mergers and acquisitions. 

Pros & cons of stocks

Pros:

1. Capital Appreciation: Historically, stocks are one of the best investment options when it comes to appreciation over time. On average, a well-diversified portfolio grows around 10% annually. 
2. Dividends: If you want your investment to also generate some income, you could exclusively invest in dividend stocks. These guarantee payments to investors every so often (usually quarterly). Dividend payouts tend to hover between 3 and 5% of your investment. If you want that income to be meaningful, you’ll have to invest a lot.
3. Ownership Rights: For most folks, this won’t mean much. But, if you buy common stocks, you get the right to participate in shareholder meetings and vote on company decision making. That the weight of your vote is proportional to your investment in the company though. Unless you own a measurable amount of a company, your vote is basically useless. Like tossing a shot glass of water onto a forest fire.
4. Liquidity: As a general rule, buying and selling stocks is fairly easy. If you need quick cash, selling stocks tends to be a reliable way to get it.

Cons:

The major downside to stock market investing is that there is inherent risk involved. Stock prices rise and fall like the tides of some vast and incomprehensible ocean. That means, in the short term, market volatility could wash away your investments faster than a sand castle in a hurricane.

It’s worth noting, however, that well-diversified investments tend to appreciate in the long term. Pulling your money out of the market in a recession is usually the opposite of what you want to do.

What are bonds?

Bonds are IOUs that companies, governments, or other entities sell as a way to raise money. When you buy a bond, you’re basically lending money to whomever sold it. Of course, you get some benefits for doing this. 

Most bond agreements also include interest payments. The issuing entity pays these at regular intervals to anyone who bought a bond from them. So, bonds tend to be relatively safe investment vehicles that also offer a minor but guaranteed income stream.

Interest income from bonds is unlikely to amount to much. Bond interest rates tend to be much lower than, for example, expected annual growth from a stock investment. 

As of 2023, federal government-issued bonds had an interest rate of 4.3%. This means a $10,000 investment would earn you a whopping $430 per year.

If you still want to invest in bonds, there are a few ways to do so:

1. Buy them from the government. If you want a bond backed by the federal government, you can buy them directly from the government’s website.
2. Brokerage firms. If you already work with a brokerage firm, you can buy bonds from them just as easily as buying stocks. Though, they’ll probably charge you some fees. 
3. Bond funds. Bond funds are mutual funds or exchange-traded funds (ETFs) that invest in a diversified portfolio of bonds. 

Bond funds offer the benefits of professional management, diversification, and liquidity. This is because you buy and sell them on exchanges similar to stocks.

Types of bonds

There are various types of bonds, each with its own risk and return characteristics:

1. Corporate bonds: Companies issue these bonds to finance their operations or growth. They typically offer higher interest rates, however, come with higher credit risk. Most companies are more likely to default on their debt obligations than Uncle Sam.
2. Government bonds: Issued by national governments, these bonds are usually the safest type of bonds due to their low default risk. However, these bonds generally offer lower coupon rates than those issued by a corporation.
3. Municipal bonds: Issued by state and local governments, these bonds are mostly lower-risk investments than the corporate variety. They are higher risk than bonds backed by the federal government, however. One unique feature of municipal bonds is that their interest payments are often exempt from federal and/or state income taxes.

Pros & cons of bonds

Pros of Investing in Bonds:

1. Predictable Income: Bonds’ coupon payments provide a regular (but small) income stream. This makes them an attractive option for those seeking consistent cash flow, such as retirees or income-focused investors.
2. Lower Risk: Compared to stocks, bonds generally have a lower level of risk. Government bonds, in particular, are about as risky as a children’s roller coaster.
3. Diversification: If your portfolio only consists of stocks, bonds are a way to add some diversity. Bonds tend to perform differently from stocks. If stock prices tank, your bonds may hold their value.

Cons of Investing in Bonds:

1. Lower Returns: Unfortunately, the best way to make money is to risk it, and bonds aren’t risky. The returns you can expect from bonds tend to be lower than those from a long-term stock investment.
2. Interest Rate Risk: When interest rates rise, bond prices tend to fall. This is because newly issued bonds with higher coupon rates become more attractive to investors. As a result, bondholders may face losses if they need to sell their bonds before maturity.
3. Inflation Risk: The fixed income generated by bonds can lose purchasing power over time due to inflation. When inflation is high, the interest rate on bonds may not be enough to keep up. 

What are mutual funds?

Mutual funds pool the money of multiple investors to purchase a diversified portfolio of stocks, bonds, or other assets. A professional fund manager oversees the investing. They make decisions about which assets to buy or sell based on the fund’s investment objectives and strategy. 

Mutual funds offer several advantages and disadvantages. Before we get to that, let’s cover the different types of mutual funds you’re likely to encounter.

Types of mutual funds

1. Equity funds invest primarily in stocks and aim for capital appreciation. There are more categories based on market capitalization, investment style (growth, value, or blend), or industry sector.
2. Fixed-income funds invest in a diversified portfolio of bonds of all varieties. Fixed-income funds generally aim to provide regular income for their investors, as well as preserving the invested capital.
3. Balanced funds invest in a mix of stocks and bonds to balance the potential for capital appreciation and income generation. The specific allocation between stocks and bonds depends on the fund’s objectives and risk tolerance.
4. Money market funds invest in short-term, high-quality debt securities, such as Treasury bills. These funds focus on capital preservation and liquidity, typically providing lower returns than other mutual fund types.
5. Index funds seek to replicate the performance of a specific market index such as the S&P 500. They invest in the same assets as the index, so they perform similarly. Index funds typically have lower fees and expenses compared to actively managed funds.

Pros & cons of mutual funds

Pros:

1. Diversification: Mutual funds invest in a wide range of assets, spreading risk across multiple investments. This diversification helps protect investors against significant losses.
2. Professional Management: Mutual fund managers have the experience and resources to make informed investment decisions. This can potentially lead to better returns and risk management compared to managing your own portfolio.
3. Liquidity: You buy and sell mutual fund shares at the end of each trading day. This allows investors to easily access their funds or make changes to their investment strategy.
4. Investment Minimums: Many mutual funds have relatively low initial investment requirements, making them accessible to a wide range of investors.

Cons:

1. Fees and Expenses: Mutual funds charge fees for their professional management and operational costs. This can reduce investors’ overall return on investment.
2. Less Control: Investors in mutual funds have limited control over the specific assets within the fund’s portfolio. This can be a drawback for investors who prefer to make their own investment decisions or have a unique investment strategy.
3. Tax Inefficiency: Mutual funds may generate taxable events even if an investor does not sell their shares. This can create tax liabilities for investors who hold mutual funds in a taxable account.

Stocks:

Stocks are the highest-risk, highest-reward investment option out of the three. They represent a tiny piece of ownership of the company who sold the stock. They’re generally easy to buy and sell quickly if you need to liquidate assets.

In the long term, a well-diversified stock portfolio should appreciate at about 10% annually. This far outpaces bonds and mutual funds’ expected growth.

Bonds:

Bonds are IOUs sold by governments, corporations, or municipalities. They offer an allegedly guaranteed return on investment. You also get regular coupon payments (usually every six months) based on a variable interest rate.

Widely considered the safest types of investments, don’t expect higher returns like with stocks. As of this writing, a US government I Bond offers a 4.3% interest rate. This is much lower than the 10% you could expect long-term from a diversified stock portfolio.

Mutual funds

Mutual funds allow many low-level investors to pool their resources and invest in a mutual fund with specified investment goals. Then, a mutual fund manager makes decisions about how to invest based on those goals.

Mutual funds tend to be safer investments and have a low bar to entry in terms of investable capital. You do, however, end up paying management fees to your mutual fund manager, which reduces your overall return on investment.

Which is better, stocks, bonds, or mutual funds?

Depends on what you’re looking for. If you want the highest possible return on investment, stocks are the way to go. 

If you want the safest possible home for your money, government-issued bonds are probably the way to go. Mutual funds tend to fall somewhere in the middle. Money market funds, however, are often the safest investment overall.

Are mutual funds safer than stocks and bonds?

A mutual fund is going to, overall, be safer than any individual stock, as it’s inherently diversified. Bonds, on the other hand, can be a safer home for your money than a mutual fund. Government bonds are especially safe, as government credit tends to be quite good.

What is the downside of a mutual fund?

A mutual fund, though relatively safe, does come with some downsides. High fees tend to be the most relevant issue. There are a couple other reasons you may not want to invest in a mutual fund, however.

Tax inefficiencies are another big one. You cannot control disbursements from mutual funds. As a result, you may have unpredictable tax events that cost you more money than they make you come tax season.

What is the safest type of mutual fund?

Money market funds are the safest type of mutual fund, generally speaking. As a result, they also have the lowest return on investment.