I’ve had a couple people ask me about the difference between these various asset classes. Now, I am NOT a financial advisor, but I’m putting the definitions in plain language because I remember that before I started investing, just getting the terminology was a pain. It’s difficult to feel confident about what I’m doing when I didn’t even speak the “language” (kinda like studying for the sentence correction section. I mean, appositive noun modifiers? Huh?!)
Stocks, bonds, and cash are the three broad asset classes, or groups of asset. When people talk about asset allocation, they are talking about how to split your portfolio (pool of money) into these three groups.
Stocks (also known as equity): Stocks = ownership in a company. I am buying a share (partial ownership) of a company’s future earnings. So if I buy a stock in Google, I am in essence buying a tiny part of Google. As a shareholder, I have the right to part of its earnings.
Bonds (also known as fixed): Bonds = loans to a government entity or a company. When I buy bonds, I am lending money to a company, and the company will pay me back the principal with interest.
Cash (also know as… cash): Cash = cash or cash equivalents (i.e. financial instruments that can be easily converted to cash, such as Treasuries, or loans to the Federal Government).
Why are stocks considered riskier than bonds?
If a company goes bankrupt, it must pay its lenders (the bond-holders) before its owners (the stock or shareholders). So in a grossly simplified example, if a company goes bankrupt and sells its plant for $100, every single lender have dibs on that $100 before the shareholders would see a penny of it. Basically, bond-holders come before equity-holders if the company goes kaput.
On the other hand, as a shareholder, I would have much more “upside” if a company does well. A bond-holder at Google will receive his/her repayment with interest, but a shareholder can benefit from the share appreciation (share of Google goes from $400 to $700 – viola! you now are $300 richer because your share of Google is worth more) and capital gain (if you buy at $400 and sell at $700).
Bonds are less volatile (the value of your return is more stable), and stocks are more volatile (value of your return is uncertain).
In the long run, stocks are considered to be a better bet because you have the opportunity for the “upside”, and you have the time to “ride out” the volatility of the price. In the short run, stocks are a dicey bet, because it’s very difficult (some say impossible) to predict how the direction and the magnitude of price moves.