Stocks, Bonds, and Funds

Buying one share of stock makes you a tiny part-owner of that company. Its value rises and falls with the market's view of the company's future profits, and some companies pay part of their profit back to shareholders as a dividend. Own the stock, and you own a real, if small, stake in whether that business does well.

Ownership means nobody legally owes you anything. A bondholder has a contract; a stockholder has a residual claim — a right to whatever's left over after every bill, every employee, and every lender has been paid. That's why a stock can go to zero: if a company goes bankrupt, stockholders are paid last, after every creditor and bondholder, and often there's nothing left by the time it's their turn. The same feature that gives stocks their higher potential upside — you own the profit, not a fixed payment — is exactly what leaves shareholders with the least protection when things go wrong.

Buying a bond means lending money — to a government or a company — for a fixed period, in exchange for regular interest payments and the return of your original amount at the end. Bonds are generally less volatile than stocks and pay a lower average return in exchange, which is the trade most investors are making when they hold both.

Unlike a stock, a bond comes with an actual legal obligation. The issuer owes you those interest payments and that principal back, on a schedule stated in the contract, regardless of how well the business is doing that quarter. That obligation is also why bondholders get paid before stockholders if the issuer goes bankrupt — a company can suspend a dividend at will, but skipping a bond payment is a default, with legal consequences. It's a narrower promise than ownership — a bond can't multiply in value the way a growing company's stock can — but it's a promise with teeth, which is exactly what a stock isn't.

A fund pools money from many investors and buys a large basket of stocks, bonds, or both in one purchase — an index fund tracking a market benchmark is the most common kind, and it's covered in full two chapters ahead. One share of a fund can represent hundreds or thousands of underlying companies, which is how most people get diversification without buying each piece individually.

Funds split into two management styles that end up mattering more than most people expect. An index fund just buys everything in a benchmark and holds it, with no one picking stocks. An actively managed fund pays a team of people to try to pick winners and beat that benchmark — which costs more to run, and which most active funds fail to do consistently enough to justify the extra cost, once that cost is measured honestly over a full decade rather than one good year.

Every fund charges an expense ratio — a percentage of your investment taken automatically, every year, straight out of the fund's assets. There's no separate bill for it and no line item on a statement to notice; it's simply deducted before any return is reported to you, which is exactly why it's the fee people are most likely to never actually see.

A typical index fund charges around 0.03% a year. A typical actively managed fund charges closer to 1%. That one-percentage-point gap sounds trivial — until it compounds against the same money for thirty years.