Stocks and bonds are the two main investment features that we will use in order to travel on our path to FI. But what is the difference and why does it matter? Whatever your risk tolerance is will decide on how what percentage of stocks vs bonds you will hold on to.
Stock = Shares = Equities
Those words are all interchangeable and they mean that you have partial ownership of a company’s assets. That includes the company’s cash, inventory, accounts receivable, land, building, and equipment. If for some reason the company becomes dissolved then all of those assets mentioned will be sold off and the proceeds will go to all of the shareholders. However, that is only after all of the creditors have been paid off and sometimes that means that all of the shareholders stock value goes to zero.
You earn money from a stock two different ways, dividends and capital gains. Dividends are profits that are earned by the company and are chosen to be paid back to stockholders, typically 4 times a year. The amount of dividend paid back is a choice (not guaranteed) made by the company and is used to entice people to purchase more stock. You have to pay taxes on dividends in the year that they are paid out and they are taxed at the capital gains rate (see chart below) for qualified dividends and your income tax rate for unqualified dividends.
Capital gain is the profit earned after selling your stock. I.E. If you purchased a stock at $10 per share and sold it at $11 per share then the capital gain is $1 per share. You are taxed on the capital gain only when you sell the stock. There are two different ways you can be taxed on your capital gains: short term and long term.
Your capital gains are considered short term when you hold the investment for less than one year. The monies earned are considered income and are taxed at your standard income tax rate. If you hold your stock for more than 1 year and then sell it, your profits are taxed at 0%, 15%, or 20% depending on your income. See the chart below for the 2019 long term capital gains tax chart:
| 2019 Long Term Capital Gains Rate (Based on Income) | |||
| Single | Married Filing Jointly | Heads of Household | |
| 0% | $0-39,375 | $0-$78,750 | $0-52,750 |
| 15% | $39,376-$434,550 | $78,751-$488,850 | $52,751-$461,700 |
| 20% | Over $434,550 | Over $488,850 | Over 461,700 |
Because you are investing in a company when you purchase a stock you are basically putting all of your eggs in one basket. The stock is solely based on how that one company does and has the ability to go to zero or increase exponentially. Therefore stocks are considered more volatile than bonds. See @#)(*@#$)#@ hyperlink Index Fund Fundamentals for how that becomes an advantage to us.
Bonds are a different animal where there is a defined rate of return. Bonds are issued by companies, municipalities, states, and sovereign governments to finance projects and operations. When taken down to the core a bond is effectively a loan given by the investor (You) to the borrower (company, municipality, etc.). Bonds are usually issued in $100 or $1,000 increments and have a defined interest rate (currently around 4%). The duration of the bond can be anywhere from 1 year to 30 years.
For example, let us say you purchase a 5 year, $1,000 bond at a 4% interest rate through your state government. At the end of the 5 years you will be paid the face value of the bond. (NOTE: you can actually purchase a bond for more or less than the $1,000 face value but we will not get into those details in this article.)
The 4% is a guaranteed rate of return that is paid on an annual basis. This means that you will be paid $40 per year for every year of ownership. At the end of the 5 year period you will have made $200. The money that you have gotten back will be $1,200.
Have the next section in two columns as a comparison
Stocks
*You own part of the company
*You can lose everything you put into a stock (More Volatile)
*The percentage earned is a product of how well the company does
Bonds
Related Articles
-Qualified vs Un-qualified dividends
-Should I Re-invest my Dividends?
-Index Fund Fundamentals
