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An investment makes money in one of two ways: By paying out income, or by increasing in value to other investors.
Income comes in the form of interest payments, in the case of a bond, or dividends, in the case of stock. Interest payments on bonds are meant to be steady and reliable—when a bond doesn’t meet its payments, it is in default. Stock dividends can and do vary. A company has no legal obligation to pay out a dividend, and may have to cut it if earnings fall. On the other hand, unlike with a bond, businesses can raise their dividends when times are good.
Most investments are also traded on the market, so that means their value, if you tried to sell them, can rise or fall every day. The most familiar example is with stocks: If other investors see good prospects for higher company earnings or fatter dividends, they may push the price of the stock upwards. Or they may just sense that other investors are feeling more optimistic, and buy simply on the hopes of riding an ebullient market. Likewise, bad news or investors’ bad moods can force prices down.
Bonds, too, change their prices every day on the market. A high-quality or government- issued bond will usually pay off in a predictable way if you hold it until it “matures” and pays back its principal, but in the meantime its value can vary. For example, if prevailing interest rates go up, the prices of existing bonds must fall so that they pay prospective investors, in effect, a comparable rate. Likewise, the value of bonds will rise when interest rates fall. A bond’s price can also fall if investors think that there is an increased chance that it will default on its obligation to pay interest, or rise if they think its credit-worthiness has improved.
If you hold investments outside of a tax-advantaged account like an IRA or 401(k), the source of the returns on your investment will matter at tax time. Bond income, stock dividends and the capital gains realized when selling an appreciated investment are all taxed at different rates.