James d. Gwartney

Diversify Your Assets
After savings accounts at banks, the two most common financial assets are stocks and bonds.
Let’s make sure you understand the nature of these two instruments. Stocks
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represent
ownership of corporate businesses. Stock owners are entitled to the fraction of the firm’s future
revenues represented by their ownership shares
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. If the business generates attractive future
revenues, the stockholders will gain. The gains of stockholders typically come in the form of
either dividends
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 (regular payments to owners) or appreciation in the value of the stock. But,
there is no assurance the business will be successful and earn income in the future. If
unsuccessful, the value of the firm’s stock will decline. While the stockholders are not liable
for the debts of the corporation, they may lose all of the funds used to purchase the stock.
(Note: “Equity” is another term for stock.)
Video:
How the Stock Market Works
Bonds
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provide businesses, governments, and other organizations with a convenient
way to borrow money. These organizations acquire funds from bond purchasers in exchange
for the promise (and legal obligation) to pay interest and repay the entire principal
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 (amount
borrowed) at specified times in the future. As long as the organization issuing the bond is
solvent, the bondholder can count on the funds being repaid with interest.
All investments involve risk. The market value of a corporate stock
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investment can
change dramatically in a relatively short period of time. Even if the nominal return
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is
guaranteed, as in the case of high-quality bonds, changes in interest and/or inflation rates can
substantially change the value of the asset. If you have most of your wealth tied up in