Matt C. has a confession: "When my friends start talking about investing I just nod my head and pretend to know what they're talking about. ... I'm too embarrassed to admit that I don't know the difference between a stock, a bond and a mutual fund." You're in a safe place with us, Matt. This episode of Motley Fool Answers (which you can download for free iTunes and Stitcher ) will help you -- and others -- hold your own the next time the topic arises.

Transcript

ALISON SOUTHWICK:

Hey, there. This is Motley Fool Answers. I'm Alison Southwick, and I'm joined, as always, by Robert Brokamp and Dayana Yochim, personal finance experts here at The Motley Fool.

Today we're going to head to the Mailbag to answer a question that maybe even you might be too embarrassed to ask. That's OK, because this is a safe place, unless you're wearing clogs, in which case Dayana is going to make fun of your footwear, even though they're very comfortable and you have a long walk to work every day.

ROBERT BROKAMP:

I don't think I've ever worn clogs, actually.

DAYANA YOCHIM:

Good for you.

ALISON SOUTHWICK:

Bury me in my clogs. They're fine. Alright, so, let's get to today's question. This comes to us from Matt C.:

When my friends start talking about investing, I just sort of nod my head and pretend to know what they're talking about. I have been doing this for so long I'm too embarrassed to admit that I don't know the difference between a stock, a bond, and a mutual fund. Help me sound smart.

We are here to help you (and all of you listeners, not just Matt C.) sound smart. So, we're going to start with some basics here -- we're going to define stocks, bonds, mutual funds to start -- and we're going to make you sound smarter at cocktail parties ... or at least know what other people are talking about.

DAYANA YOCHIM:

Actually, one of my favorite parts of Andrew Tobias' book, The Only Investment Guide You'll Ever Need, is a chapter buried at the end that's basically, "lines you can use at a cocktail party to sound smug and impressive." He's talking about ways to insert totally obscure investing terms in a sentence so that people are just standing there looking at you in awe and won't admit that they have no idea what you're talking about.

ALISON SOUTHWICK:

Right. You just nod and go, "Yeah, yeah. I got a guy. You know, oil prices. Pork belly futures. Money figures."

DAYANA YOCHIM:

Right.

ALISON SOUTHWICK:

So, let's start off with stocks. Dayana, why don't you kick us off and define for us what a stock is.

DAYANA YOCHIM:

So, when you buy a stock in a company, you're not just buying a slip of paper or stock certificates. (In the olden times, they'd give you those.) You are actually becoming a part owner of that company and, in very technical terms, you are a shareholder. You get to brag about being a shareholder with a bunch of bragging rights at cocktail parties.

For example, as a shareholder, you're entitled to take a portion of the company's profits either through dividends or capital appreciation, otherwise known as growth. Shareholders also get voting rights, so when it comes time to elect folks for the company's board of directors or to vote on corporate policy, you, dear shareholder, get to vote. You get to cast a vote.

Plus technically, you, along with all the other shareholders, own the corporation. Midcentury modern lobby furniture. The CEO's mahogany desk. The broken copy machine. You literally own a portion of this company.

ROBERT BROKAMP:

You just hold the certificate, walk into the building, and say, "I would like this."

DAYANA YOCHIM:

I demand a stapler.

ALISON SOUTHWICK:

Not even a staple, probably.

DAYANA YOCHIM:

No, not even a staple for most of us. Because how much of the company's profits you get [and] how much your vote counts -- how many staples you own -- is weighted by the number of shares of stock you have.

ALISON SOUTHWICK:

And most companies have like millions of shares outstanding.

DAYANA YOCHIM:

Right.

ALISON SOUTHWICK:

And so you still matter, but you own like half of a paper clip or something like that.

DAYANA YOCHIM:

But you are a shareholder.

ALISON SOUTHWICK:

And that matters.

DAYANA YOCHIM:

It really does.

ALISON SOUTHWICK:

One of Tom and David Gardner's (they're the co-founders of The Motley Fool) ... one of the stories that you hear when you come to work at The Motley Fool is how they got started investing. They were at the grocery store with their father, and they were walking down the aisle and their dad says, "You know what? We're going to buy some chocolate pudding, and by the way, we own stock in this company that makes this chocolate pudding, so you should feel good. You get pudding." So, from a very young age, Tom and David Gardner associated investing and owning stock in a company with getting to eat pudding, which is great. Who doesn't like pudding?

ROBERT BROKAMP:

I do that with my kids when we go to Home Depot or Starbucks. I say, "We are shareholders since we own part of it. So go in there, take some coffee and run."

ALISON SOUTHWICK:

At least cut in line.

ROBERT BROKAMP:

Exactly. Exactly.

ALISON SOUTHWICK:

Then, is there anything else we want to add on top of that?

ROBERT BROKAMP:

Well, people might ask why stocks exist at all. And basically, the people who founded the company have decided to go public and issue stock. They're basically selling part of the company to shareholders in order to get money to invest.

DAYANA YOCHIM:

To raise money.

ALISON SOUTHWICK:

To raise money for the company to invest.

ROBERT BROKAMP:

Right. The company -- let's say they want to build a factory. They will use the proceeds from issuing stock to do that. It's a way for them to grow their business -- it might even be to pay for marketing or something like that. They need that extra capital, so that's why they will issue shares. 

ALISON SOUTHWICK:

Cool. All right. Let's move on to bonds, because this is considerably less exciting than stocks, I think. When people talk about investing in the stock market, it's sexy, kind of. But no one ever brags about some sweet bond they bought.

ROBERT BROKAMP:

No, which is funny, because actually the bond market is bigger than the stock market. Part of the reason is because stocks are issued by corporations. So are bonds, but also the federal government issues bonds -- state and local governments. So, it's actually almost twice as big.

A bond is debt. So, if you want to raise capital, instead of selling part of your company, as you would with stocks, you're looking to borrow money.

Let's say you buy a thousand-dollar bond -- it could be from your local school district or GM -- at a 3% interest rate. You buy the bond. They get a thousand dollars. They pay you $30 every year until that bond comes due and then you get your thousand dollars back. It could be three years, five years, 10 years, 20 years. Generally speaking, the longer the time frame, the higher the interest rate.

Historically bonds are much less volatile than the stock market which is why people own them -- people like retirees. But there is a difference. The safest bonds in the world are actually Treasuries issued by Uncle Sam. You get like 2-3% maybe.

Then there are things called junk bonds issued by companies that, you know, are a little sketchy. You don't know if you're going to get your money back. They're paying like 8-10% -- the old risk and return thing. If you want to take a little more risk with your bonds, you might get a higher interest rate, but you also might end up losing all your money.

ALISON SOUTHWICK:

Then bonds, generally though, are less risky. You're going to make less money than you are with stocks, which are going to be more risky. I feel like we're often told, "Well, when you're younger, you should own more stocks than bonds. Then when you get older, you should own more bonds and fewer stocks."

ROBERT BROKAMP:

Right.

DAYANA YOCHIM:

What's so weird is that bonds are -- or have been, in the past -- such popular bar and bat mitzvah gifts.

ALISON SOUTHWICK:

Oh! Really!

DAYANA YOCHIM:

These are young people. You should be giving them a stock!

ALISON SOUTHWICK:

Yeah, yeah.

DAYANA YOCHIM:

I think I still have a bond that was a gift that's still maturing.

ALISON SOUTHWICK:

This is kind of a selfish question. I think I maybe have a bond in like a dresser drawer somewhere that probably already matured. Am I still making money off of that?

DAYANA YOCHIM:

No.

ALISON SOUTHWICK:

Oh!

ROBERT BROKAMP:

You're not. If it's a Treasury bond or a savings bond, you just go to your local bank, actually, and they'll take care of it. If it's a corporate bond, you're going to have to dig a little deeper for that.

But as far as performance for younger people, for example, there's really only been one 30-year period since the 1800s when bonds beat stocks. All other 30-year periods, stocks have outperformed bonds. Now when was that 30-year period? It was actually very recent, from 30 years ending with 2009 backwards. So, right at the teeth of the Great Recession, when the stock market dropped 50%, you look at that period and that's actually when bonds beat stocks.

So, there is risk with the stock market if your portfolio drops 50%. I think the worst 12-month period for a bond was like a drop of 7-8%.

ALISON SOUTHWICK:

Obviously, we do a whole show on every single one of these topics.

ROBERT BROKAMP:

Right.

DAYANA YOCHIM:

But next time we're back here, I want to hear that you have taken that bond to the bank and cashed it in because you can be doing something better with that money right now.

ROBERT BROKAMP:

Yeah. I'm curious, now.

DAYANA YOCHIM:

And also for people out there -- if you do have bonds, it's like cash. If you lose it, it's like losing cash. I don't think there's any way to really look it up.

ALISON SOUTHWICK:

So, when I say that it's in my dresser drawer, that's my way of saying I have no idea where it is. So, my dresser drawer is this black hole keeper of all the things that I have lost throughout my life, and in there are some bonds. There's probably some t-shirts I borrowed from old boyfriends. I don't know. There's a lot of fun stuff in that dresser drawer.

DAYANA YOCHIM:

Some bad investments that you made.

ALISON SOUTHWICK:

I have no idea what you're talking about. I've never made a bad investment ever.

Let's move on. So, stocks. Bonds. Now it's time to talk about mutual funds. We pretty much all have them.

DAYANA YOCHIM:

Yeah. There are trillions of dollars in mutual funds. And I think that something like 80% of people who are invested ... I'm totally butchering this statistic. Let's just say that everybody owns mutual funds. 112% of people are invested in mutual funds.

ROBERT BROKAMP:

One of the big reasons is most people are investing through their 401(k) or 403(b), and those are almost exclusively invested in mutual funds.

ALISON SOUTHWICK:

The first thing that pops in my mind when we talk about defining a mutual fund is it's a basket of stocks. So, Dayana, take it away. Tell me about this basket of stocks.

DAYANA YOCHIM:

Well, this lovely basket of stocks ... it's assets. It doesn't have to just be stocks. It can be bonds. It can be cash. It can be other securities. The money used to invest in these assets in the mutual fund comes from a pool of funds contributed by many investors -- those trillions of investors. They mutually fund it -- get it? It's a mutual fund.

ROBERT BROKAMP:

Right.

DAYANA YOCHIM:

Okay. So, when you invest in a mutual fund, you're actually buying a portion of the holdings of the fund. Most mutual funds are run by money managers. They decide how to invest the funds. Their decisions are based on the investment objectives set out for the fund, or the goal of the fund.

For example, if the objective is to find opportunities from overseas companies, they'll look at foreign stocks and other ways to get exposure to foreign markets. If they're looking for growth, the money manager will look for companies with more potential to increase in value and keep less of the money in the fund invested in cash or bonds. And for income and things, they'll stick to fixed income or dividend-paying companies and invest more in bonds and those sorts of things.

ROBERT BROKAMP:

And that's a good point there -- mutual funds have everything. Oil futures. I mean, you name it. And it's helpful because the average person may not want to go out and try to pick particular oil futures. So they basically have a manager doing that for them.

DAYANA YOCHIM:

Of course, you pay for that fund manager to pick something and the fees you pay are taken directly out of your investment. Every dollar that you're paying to the mutual fund company is a dollar that's taken out of commission for you -- it's no longer working for you.

You're paying the fund manager, paying for the input from all of his staff (his or her staff), the other costs of running it like sales, statements, TV ads, salaries. All of that stuff. So, the fees are really at the crux of what we, at The Motley Fool, look at when we're looking at mutual funds.

ALISON SOUTHWICK:

What is a typical mutual fund fee?

ROBERT BROKAMP:

It varies by asset class, but the average, generally, is 1.4% or 1.5%. Bond funds tend to be cheaper. Large company U.S. stock funds are cheaper than small international stock funds. But around 1% is about what most people would see. If you take the whole average, it's like 1.4% or 1.5% and you're getting pretty high at that point.

ALISON SOUTHWICK:

And that's for mutual funds that have a guy or gal in a suit moving money around.

ROBERT BROKAMP:

It could be a monkey suit. A gorilla suit...

DAYANA YOCHIM:

The fees can go a lot higher than that, too.

ROBERT BROKAMP:

Right. We'll talk about that a little later. And just so everyone knows, we do have a bear suit and a chicken suit here at The Motley Fool, I believe.

ALISON SOUTHWICK:

Yeah. So, guys and gals in monkey suits. Pantsuits. Whatever kind of suits -- managing your money. That's not the only kind of mutual fund.

ROBERT BROKAMP:

Right. You can have a mutual fund that you don't really have anyone picking those investments. They're basically just copying an index. An index most people are comfortable with or have heard of -- the S&P 500, Dow Jones...

ALISON SOUTHWICK:

And what is an index?

ROBERT BROKAMP:

An index, OK. That is something that a company has created to measure a segment of the market. The Dow and the S&P 500 were created so that we could say, "The overall stock market made 10% or lost 50%." It's just a way to measure a broad class of some kind of asset. But there are indexes based on all kinds of things -- small caps, large caps, bonds...

DAYANA YOCHIM:

Countries...

ROBERT BROKAMP:

...Treasuries. Countries ... all kinds of real estate indexes and things like that. But the great thing about it is instead of hiring this team of people in all kinds of crazy suits, they're just copying whatever the S&P 500 does, or whatever index it is, and they just have to pay a licensing fee, to, in this case, S&P 500, Standard & Poor's. But it basically makes the cost something like 0.1% or 0.2% as opposed to 1.2-1.4%.

You may think that that's not a big deal. When you compound that over 10, 20, or 30 years, you are basically cutting your net worth by a third by the time you get into retirement.

DAYANA YOCHIM:

Yes, it's crazy how much the fees add up. And the performance of an index fund is often not too shabby. Like you might feel like your 1.4% is going toward the guy in the suit and it's money well spent because he's smart and he knows what he's doing, but the truth is index funds are fine. The market does pretty well on its own.

ROBERT BROKAMP:

In fact, they're more than fine. Over the long term, index funds outperform the majority of actively managed funds, which is surprising. You'd think if you were paying someone a lot of money to pick stocks or bonds or whatever, they'd do better. The chances are they're probably not doing better.

DAYANA YOCHIM:

And one of the reasons they're not doing better is because you have to pay them and the company that they work for to do it... 

ROBERT BROKAMP:

Right. It's mostly due to those costs. That's actually why it's so hard.

ALISON SOUTHWICK:

So, then the last thing we wanted to talk about was not in Matt's question, but we're still going to talk about it and that's CDs.

ROBERT BROKAMP:

Right. Not the musical variety -- which I guess even fewer people even know about. I make a Christmas CD, every year, and people tell me, "I don't even have anything to play a CD anymore." It's very sad.

Anyway, CD stands for certificate of deposit. Mostly you get them from banks, although some brokers will sell them. The point here with a certificate of deposit -- you can go to a bank and get a checking account or a savings account. You put your money in and you have access to your money any time you want. You have a certain interest rate.

With a certificate of deposit, you're locking up your money -- six months, a year, two years, three years -- but because you're locking up that money, you get a higher rate. Now, it's not a big deal these days. While you get maybe 0.3% on your savings account, according to Bankrate.com. But if you get a three-year CD, you're making 1.5% or 1.6%, but you do have to lock it up. Now you can get the money if you need to, but then you have to give up three [to] six months' worth of interest.

But it's safe. Most of them are FDIC insured, which basically means if the bank fails, the government will cover that. It's really for safe money. If you have an expense coming up soon -- let's say your kid's going to college in three years -- get a three-year CD. You know the money's going to be safe. It will come to you and you'll spend it that way.

DAYANA YOCHIM:

You get a little more interest than you're getting in your regular checking or savings account.

ROBERT BROKAMP:

When interest rates were normal, where you'd get 3% on your cash, the difference between a savings account and CD was much more worthwhile.

ALISON SOUTHWICK:

So, is the CD going to keep up with inflation?

ROBERT BROKAMP:

No, and that is a great point. And when you talk about CDs, cash, or even bonds -- another word for bonds and these things is called fixed income, because you get that same amount every year -- you have to consider that general costs of living keep going up. That's another risk of playing it too safe. You talk about 20, 30, or 40 years, you're going to retire then. If you're just staying with fixed income, you might be losing out to inflation.

ALISON SOUTHWICK:

I think that covers Matt's question. I think we're going to help him sound more intelligent at cocktail parties, or at least when he's nodding his head and saying, yes, he actually does know what they're talking about.

DAYANA YOCHIM:

He might want to consider getting some fake reading glasses, too.

ALISON SOUTHWICK:

Oh, that is a really good idea. And a pipe?

ROBERT BROKAMP:

I'll bring my pipe to the next one. I'm also going to hope that I have been invited to a cocktail party, because I have not been to a party that was labeled a cocktail party in years.

ALISON SOUTHWICK:

Do the kids not have...? I guess the kids don't really have cocktail parties.

All right, guys, that's going to do it for us today. If you have questions, embarrassing or otherwise, that need answers, we are here to help and we're here at Answers@Fool.com. Also, if you would be so kind as to rate us on iTunes and Stitcher and maybe even leave a comment on how we're doing, we'd really appreciate the feedback.

So, for Robert and Dayana, I'm Alison Southwick. Fool on!

[End]

Alison Southwick has no position in any stocks mentioned. Dayana Yochim has no position in any stocks mentioned. Robert Brokamp, CFP owns shares of Home Depot and Starbucks. The Motley Fool recommends Home Depot and Starbucks. The Motley Fool owns shares of Starbucks. Try any of our newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.