What you will learn
- Explain what a stock is and how a shareholder can make money
- Explain what a bond is and what the borrower promises to pay
- Describe why investors keep cash even though it earns little
- Compare the risk of stocks, bonds, and cash, including who gets paid first if a company fails
Most investment portfolios use some mix of stocks, bonds, and cash. Each one has a different job. A stock makes you an owner, a bond makes you a lender, and cash gives you money you can use right away.
Stocks: owning a slice of a business
A stock, also called a share or equity, is one unit of ownership in a company. If a company has one million shares and you buy one, you own one millionth of the business. If you buy ten thousand shares, you own one percent.
What are stocks, bonds, and cash?
Stocks, bonds, and cash get a side-by-side introduction for beginners.
A shareholder can make money in two ways. If the share price rises, the owner has a capital gain. The company may also pay shareholders part of its profits as a dividend. Shareholders take more risk, though. If the company shuts down, employees, suppliers, lenders, and bondholders are paid before them. Shareholders receive only what is left, if anything. That position is called a residual claim.
- A shareholder can earn a capital gain if the price rises and may receive dividends when the company pays out profits.
- A shareholder is paid last if the company fails and can lose the full investment.
- Shares usually include voting rights, which let owners vote on directors and major decisions.
How much of the company do you own?
A company has 4,000,000 shares outstanding. You buy 1,000 shares. What percentage of the company do you own? Enter your answer as a percent.
Bonds: lending money for interest
A bond is a loan to an issuer, usually a company or government. In return, the issuer promises to make regular interest payments called coupons. It also promises to return the amount you lent, called the principal or face value, on the maturity date.
A bondholder is a creditor rather than an owner. Creditors are paid before shareholders if a company fails, which is one reason bonds are generally safer than stocks. In exchange, bondholders give up the larger possible gains that can come with ownership and receive steadier payments instead.
Bonds versus stocks (Khan Academy)
Khan Academy puts bondholders and shareholders side by side so you can compare their risk and possible return.
Key terms
- Capital gain
- The profit you make when you sell an asset for more than you paid for it.
- Dividend
- A share of a company's profits paid out to its shareholders, usually in cash.
- Coupon
- A regular interest payment made to a bondholder.
- Principal (face value)
- The original amount of a loan or bond that is repaid at maturity.
- Maturity
- The date when a bond's principal is due to be paid back.
- Creditor
- Someone who is owed money. Creditors are paid before owners if a company fails.
- Residual claim
- A shareholder's right to whatever remains after everyone else has been paid. This puts owners last in line if a company fails.
Cash and cash equivalents
For an investor, cash includes physical money and safe, liquid holdings such as bank deposits, money market funds, and Treasury bills. Treasury bills are short term loans to the government. Cash earns little, but you can spend or invest it right away. Investors use it to handle emergencies or buy another asset when an opportunity appears. It also almost never loses its face value.
A stock makes you an owner. A bond makes you a lender. Cash is ready when you need it.
The risk and return ladder
Investors usually expect a higher long run return when they accept more risk. Otherwise, there would be little reason to choose the riskier asset. Cash has the lowest risk and expected return. Bonds sit in the middle. Stocks have the highest long run expected return of the three, along with the largest price swings. That order describes a broad pattern, not a promise about what will happen in any one year.
| Asset | You are a... | Main reward | Risk level | Job in a portfolio |
|---|---|---|---|---|
| Cash | Holder | Small interest and a stable value | Lowest | Safety and money that is ready to use |
| Bond | Lender (creditor) | Coupons plus your principal back | Medium | Steady income, paid before owners |
| Stock | Owner (shareholder) | Capital gains plus dividends | Highest | Long run growth with larger price swings |
Who gets paid first?
A company goes bankrupt and sells everything it owns. There is not enough cash to pay everyone. Who has the stronger claim on the money?
Creditors are paid before owners. Bondholders are lenders, so they stand ahead of shareholders, who hold a residual claim.Match the asset to your role
Pair each asset with the role you take when you own it.
How would you split it?
Imagine you have 10,000 dollars to invest and will not touch it for twenty years. How would you divide it among stocks, bonds, and cash? Explain your reasoning using what you learned about risk and return.
Write an answer before comparing it with the model response.
Model answer
With twenty years to wait, many investors might put 70 to 90 percent in stocks. The long time horizon gives them more time to live through price swings while seeking the higher expected return. Bonds could provide steadier income, and a small cash position could cover surprises. A longer time horizon usually gives an investor more room to accept short term risk.
Stocks, bonds, and cash form the base of many portfolios. Next, you will see how an exchange brings buyers and sellers together so these assets can change hands.