Beginning investors and traders of every age have more questions than answers, writes Steve Pomeranz, CFP Thursday. Look for guides on how to get started trading Fridays on MoneyShow.com.

Here’s a bond primer for those who concentrate on other things

Many times in my career I have launched into detailed discussions of the economy, interest rates and how they affect bondholders.

Often when I finish, someone will turn to me and ask, “Umm, Steve, what is a bond?” That’s when I realize that most people are not all that familiar with how bonds actually work.

If you are one of them, this commentary is for you.

Two types of investments

To begin, there are only two types of investments: either you own something, or you lend money. With stocks, you are an owner and with bonds, you are a lender.

As a lender, you can expect two things: you expect your money back at some future date and you can expect to receive a fair rate of interest during that period. The shorter the lending term, the lower the interest rate; the longer the term, the higher the rate.

The interest earned is most often a fixed percentage—2%, 3%, 8%, and so on. The rate of interest is determined not only by the length of the term but by the ability of the borrower to pay you back and the level of interest rates in the general economy.

The better the borrower’s credit, the lower the rate of interest you will receive. As with a credit card, you would expect to pay less if you had good credit and pay more if your credit was poor. The lender feels the same way.  As a bondholder, remember, you are the lender.

Let’s take it a step further. Imagine that you lent money to two of your friends. The first friend’s loan was for two years at 2% and the other for 30 years at 5%.

et’s imagine how you would feel if in the following six months interest rates in the general economy doubled for all new investments of the same type. In other words, 2% rose to 4% and 5% rose to 10%.

How disappointed would you be with the rates you originally charged? With the two-year loan, probably not so much because you’re getting your money back shortly, enabling you to reinvest at the higher rates.

On the other hand, the 30-year loan would likely be a significant disappointment. The $10,000 you loaned, which is paying you $500 per year (5%), could now pay you $1,000 per year (10%) if only you had known that rates were going to rise. Alas, it’s too late because you are now committed to receiving $500 per year for 30 years. Ouch!

What if you said, “Hey, maybe I can sell this loan [let’s call it a bond, now] to someone else and use that money to buy the new bond earning 10%?” As good as that sounds, it wouldn’t work because, frankly, who would buy your bond at 5% if they could get 10% elsewhere?

In the real world, and this is just a simulated example-not the real world, your $10,000 bond would fall in price to $5,000, thereby allowing someone to buy two of your bonds to get their 10%.

The takeaway

The takeaway? If interest rates rise during your ownership of the bond, the bond price will fall. How much will it fall? With the two-year example, not so much since you’re getting your initial investment back quickly. The 30-year bond will drop considerably more to match the going rate.

Just a note, so bonds don’t get a totally bad reputation. If interest rates fall, bond prices rise, so you can actually MAKE extra money if interest rates go down.
Keep in mind that the market value of your bond does not affect the interest you receive or the return of your original investment in the future; it only affects the money you would receive if you had sold.

To summarize:

Bonds are loans.

The interest rate is based on the maturity of the bond, the credit of the borrower, and the level of interest rates in the general economy.

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The risk? Your borrower’s ability to pay you back and the situation in which you’ll find yourself if the bond’s maturity is long-term and rates rise in the meantime.

Of course, there are numerous other factors and risks at play in the world of bonds, but this is a good start.

Investing in stocks for the beginner

Next, I want to examine the world of investing in stocks. Remember earlier I mentioned that there are only two types of investments: You either own something or you lend money.

For the purposes of this commentary, owning equals stocks, lending equals bonds.

It’s arguable, but, in my opinion, most stock investors have no idea what they are actually investing in. Typically, they buy with the hope that their stock purchase will rise in value but have no understanding of what drives the increase.

Most investors, therefore, are really just gambling with their money and, most likely, their financial future.

What is a stock?

So, what is a stock? Investopedia states:

“A stock is a share in the ownership of a company. Stocks represent a claim on the company’s assets and earnings.”

As a shareholder, you have a claim on assets such as tangible property (real estate) as well as intangible property, such as intellectual property (patents). Therefore, a claim on the earnings of a company in which you have stock means you own all current and future net earnings, which, combined with the magic of compounding, may create large amounts of wealth.

Here’s an example: In 1972 an investor bought a company which had net earnings of $4.2 million. In 1987, the company’s earnings had increased to $82 million, a 20-times increase. Nine years later, in 2007, when the investor added up all the earnings he had received to date, the amount came to whopping $1.65 billion.

How much did he pay 40 years earlier for this bounty? Only $25 million. He spent $25 million and received $1.65 billion in earnings over the course of 40 years! That is the incredible power of the claim on earnings.

But what about the actual value of this stock after the earnings had increased so dramatically?

What was the investor’s $25 million worth so many years later?  Since this company is not publicly traded, we can’t know for sure, but we can assume the following inference using the numbers just stated: He paid $25 million for $4.2 million in earnings. This means he paid about 6 times earnings and in 1987, the company’s earnings were $82 million. If we price these 1987 earnings by the same 6-times multiple, the result is $488 million.

What is this fantastic company? Perhaps a technology firm making billions changing the world or a futuristic biotech on the verge of curing cancer? Nothing so esoteric. It’s a simple candy company known as See’s Candy and the investor is none other than Warren Buffett, Berkshire Hathaway (BRK.B).

Of course, most of us don’t have $25 million to purchase an entire company; however, our individual shares represent a pro-rata ownership in the entire enterprise. So, if you were lucky enough to go in with him on this investment, your experience would have been the same based on your pro rata ownership.

Investing in stocks from the master: Warren Buffett

A few lessons to learn from Uncle Warren:

Higher stock prices in the future may be related to (among other factors) higher earnings.

Prudent investors create wealth by being patient, not by gambling or by indiscriminate trading.

Buying complicated companies is not a necessary ingredient to accumulate great wealth, so try to stick with companies you understand.

Stock-picking on your own is subject to higher risk. Consider indexing or hiring a professional to actively manage your portfolio.

Lessons from Buffett's annual letter.

Seeking professional advice before taking a risk with your financial future may be your wisest decision after all.

To find out more, go to www.stevepomeranz.com