A stock is an investment in a specific company. When you purchase a stock, you’re buying a share — a small piece — of that company’s earnings and assets. Companies sell shares of stock in their businesses to raise cash; investors can then buy and sell those shares among themselves. Stocks sometimes earn high returns, but also come with more risk than other investments. Companies can lose value or go out of business.
How investors make money: Stock investors make money when the value of the stock they own goes up and they’re able to sell that stock for a profit. Some stocks also pay dividends, which are regular distributions of a company’s earnings to investors.
A bond is a loan you make to a company or government. When you purchase a bond, you’re allowing the bond issuer to borrow your money and pay you back with interest.
Bonds are generally considered safer than stocks, but they also offer lower returns. The primary risk, as with any loan, is that the issuer could default. U.S. government bonds are backed by the “full faith and credit” of the United States, which effectively eliminates that risk. State and city government bonds are generally considered the next-safest option, followed by corporate bonds. The safer the bond, the lower the interest rate.
How investors make money: Bonds are a fixed-income investment, because investors expect regular income payments. Interest is generally paid to investors in regular installments — typically once or twice a year — and the total principal is paid off at the bond’s maturity date.
3. Mutual funds
If the idea of picking and choosing individual bonds and stocks isn’t your bag, you’re not alone. In fact, there’s an investment designed just for people like you: the mutual fund.
Mutual funds allow investors to purchase a large number of investments in a single transaction. These funds pool money from many investors, then employ a professional manager to invest that money in stocks, bonds or other assets.
Mutual funds follow a set strategy — a fund might invest in a specific type of stocks or bonds, like international stocks or government bonds. Some funds invest in both stocks and bonds. How risky the mutual fund is will depend on the investments within the fund.
How investors make money: When a mutual fund earns money — for example, through stock dividends or bond interest — it distributes a proportion of that to investors. When investments in the fund go up in value, the value of the fund increases as well, which means you could sell it for a profit. Note that you’ll pay an annual fee, called an expense ratio, to invest in a mutual fund.
4. Index funds
An index fund is a type of mutual fund that passively tracks an index, rather than paying a manager to pick and choose investments. For example, an S&P 500 index fund will aim to mirror the performance of the S&P 500 by holding stock of the companies within that index.
The benefit of index funds is that they tend to cost less because they don’t have that active manager on the payroll. The risk associated with an index fund will depend on the investments within the fund.
How investors make money: Index funds may earn dividends or interest, which is distributed to investors. These funds may also go up in value when the benchmark indexes they track go up in value; investors can then sell their share in the fund for a profit. Index funds also charge expense ratios, but as noted above, these costs tend to be lower than mutual fund fees.