'Mellody's Mail': Basic Finance for Kids

Q U E S T I O N: How do I explain to a child (elementary school age) what stocks and bonds are?

A N S W E R: With school out for the summer, now is a great time to teach your child about the basics of investing. The best way to describe stocks and bonds to your child is to use analogies that he or she will understand.

To do this, it is first important that you understand the defining characteristics of each type of investment. Stocks represent an ownership position in a company. As owners of the business, investors share in both the good and bad fortunes of a corporation. The value of a company's shares generally rises as the company grows and prospers.

On the other hand, a bond is a debt security, or IOU, issued by a company, municipality or government agency. Essentially, a bond investor is lending money to the issuer and in exchange, the issuer promises to repay the loan amount on a specified maturity date.

In addition, the issuer usually pays the bond investor regular interest payments over the life of the loan. Although bonds are a safer, more predictable investment than stocks, stocks offer higher potential returns.

That said, a simple way to explain the differences between a stock and bond to a child is to use an analogy of a restaurant. Tell your child there are three people who are involved in the business (pick three of their friends — for our example, we will use Robbie, Jimmy and Mary). Robbie wants to open a restaurant. He asks his brother Jimmy to invest in the restaurant, so Jimmy is like a stock investor.

As a part owner of the restaurant, Jimmy is subject to both the ups and downs of the business. Robbie also asks his sister Mary to lend him money to help start the restaurant, so Mary is like a bond investor — she expects to be repaid. Mary will not make as much money as Jimmy if the restaurant is a great success. However, because she is simply lending money, if the restaurant goes bust, Mary will still get her investment back, just like Robbie would repay a bank.