Stocks and Bonds are financial securities issued by corporations. Bonds may also be issued by governments. Issuers of stocks and bonds are usually raising money to fund their operations or expansion plans. For example, a company may raise money to build a specialized factory to produce a medical device, or it may wish to hire new staff to assemble a global sales team. Federal, state, provincial, or county/city governments issue bonds to fund public projects. For example, a local government may issue bonds to help fund construction of a community center, a new access road, or sewage system.
When corporations issue stocks or bonds they are raising capital, where capital is the fancy term economists use instead of simply saying “money.”
Investing in stocks and bonds allows us to share in the success of the organizations that issue them. Of course, when those issuers do poorly, we stand to lose money on our investments.
If you invest in only one company and it does poorly, you could lose your entire investment. Because investing in individual stocks and bonds can be very risky, most investors prefer to invest in portfolios of many stocks or many bonds. This can be done by purchasing pre-constructed portfolios, the most common of these are mutual funds and exchange traded funds (ETFs).
Investing in these funds has several advantages: they’re more diversified than individual stocks or bonds, and they are convenient. We do, however, pay for this convenience. The companies that put these portfolios together and manage them on an ongoing basis charge us an annual management fee. The fee is typically a percentage of the dollar amount we invest in a fund and is expressed as a Management Expense Ratio (MER). If the MER on a particular fund is 1%, and the value of your investment in that fund is $40,000, you will be charged $400 dollars annually for that investment. In practice, the fees are often drawn from your account in several installments over the course of a year. This makes them less noticeable on your statements, thereby reducing the likelihood that you will complain about them.
Mutual fund companies have been implicated over the years in various unsavory marketing and fee-setting practices. Mutual funds are also more likely to be actively managed, and hence charge investors higher annual fees. For these reasons, I recommend focusing your attention on ETFs. Having said that, qualified retirement accounts such as 401(k) and 403(b) may only offer mutual funds, so we’re stuck with them.
In practice, we hold stock and bond funds in various accounts, including: 401(k), 403(b), 457(b), SEP IRA, Solo 401(k), Roth IRA, Traditional IRA, Children’s 529 plan(s), Defined Benefit Pension Plan(s), and brokerage or investment accounts. These accounts—you can think of each of them as a pillar—are primarily distinguished by their tax-status. Most of these accounts are described in the retirement planning chapter. SEP IRA and Solo 401(k) accounts are typically offered by private practices and are therefore described in the second book of the Pillars of Wealth series: Business Essentials for Medical Practices.