INVESTING BASICS: STOCKS AND BONDS
Part #2: Stocks
By Mary Lynne Dahl, CFP®
June 11, 2013
In the last article, I explained how bonds work. In this article, I will explain how stocks work.
In Part 1, I explained that bonds, like bank CDs, are “debt investments”; when you invest in a bond you are loaning your money to the company or government that sells you the bond. Bonds pay interest and bonds “mature” over some specific period of time, generally 6 months to 30 years. The value of a bond is usually fixed but the price can fluctuate up or down, depending on interest rates, over the period of time before the bond matures. At maturity, the bond is worth “par”, which is $100 or $1,000 per unit, and you get par value paid back to you at maturity.
Corporations have several ways to raise money, which they need to start up, grow, merge with, acquire other companies and innovate. First, they can borrow from a bank, paying interest to the bank on the bank’s terms. Second, they can borrow from investors by selling them bonds, paying interest to the investors, on the corporation’s terms. Third, they can obtain financing from venture capitalists by promising the venture capitalists a significant share of the company in return for the capital, and finally, they can issue stock, which investors buy, paying the corporation for that stock, which also gives the investor an ownership in the corporation.
A stock is very different from a bond. Stock is “equity” rather than “debt”. You own part of the company whose stock you have purchased. Because you own stock in a company, you get to vote on the management of the corporation and you are entitled to some of the profits of that company. Those profits are paid from earnings, and they are paid to you as a dividend. In addition, if the stock is sold at a higher price than what you paid for it, you will get a capital gain, so you have both ways to earn income from investing in stock. A commonly-used catchy phrase is “stocks own” and “bonds owe”, as a way to remember that one represents equity investment and the other represents debt investment.
There are 2 kinds of stock; common stock and preferred stock. Common stock is ownership of shares that have voting rights and may be entitled to a dividend if and when a dividend is paid. Preferred stock is also ownership of shares but it has no voting rights. It may also pay a higher dividend than common stock.
Preferred stock has features like common stock and also like bonds. Preferred stock is entitled to a fixed income being paid to the shareowner from dividends, like the fixed interest paid by bonds, but it is equity, not debt. The fixed income is not guaranteed, however.
Stock is liquid, which means it can be bought and sold on very short notice. In addition, there are no “maturity dates” on stocks, as there are on bonds. You can buy stock one day and sell it the next. The price will change daily, and could be more or less than what you paid for it. It is not generally a good idea to buy and sell over a short period of time, as stocks should be purchased by most people for the long term, not the short term. As with all investing, it is important to be a long term thinker and commit to it with a specific goal in mind, which may take a long time to achieve.
Often, you will hear people discussing a stock as having a good “price earnings ratio”. This is called the “P/E ”. It is a comparison of the price of the stock to the earnings that stock produces from doing business. For example, if a stock sells for $35 per share and has earnings of $2.50 per share, the P/E ratio of that stock = 14. If that stock price goes up from $35 to $75 dollars and still has earnings of $2.50 per share, the P/E will rise to 30. A low P/E is better than a high P/E, because you pay less to get those earnings with a low P/E than with a high P/E. There are average P/E ratios for stocks from different corporations, and it pays to know those averages so that you do not pay more than a stock is really worth.
Dividends can be paid in dollars, called cash dividends or in more shares, called share dividends and are expressed as a percentage. Typical dividends are 2.5% to 4% for many stocks but certain types of stocks have historically paid dividends higher than that. By contrast, today (May 2013), interest paid on bonds and CDs is less than 1% for short and medium term maturities of up to a year, and as little as 2.5% on bonds and CDs of longer terms. When high-quality stocks pay dividends at higher rates than high-quality bonds, investors tend to select stocks for the income they provide instead of buying bonds.
Stock investments can be very conservative or very risky, depending on the company that you select for investment. A large, well-run company that is a well-known household brand name, has a long history of good earnings, is clearly profitable and not have too much debt, is often a conservative stock investment to own. In contrast, if you decided to invest in a very small, start-up company without a lot of financial backing and which plans to sell a product that is experimental or has just been invented, you will face a lot of risk in owning this kind of stock. Regardless of the level of risk, stocks are never guaranteed. You can lose all of your money, or make moderate profits, or even large profits. It all depends on the quality of the stocks, the price you pay when you buy, the price you receive when you sell, the dividends paid to you while you own the stock and what you do with those dividends.
There are transaction costs for buying and selling stocks. For this reason, it is not efficient to buy only a few shares. In many cases, the transaction costs are a fixed dollar amount, so if you only buy a few shares, your transaction cost is higher than if you bought 100 shares or more. For example, if the minimum transaction cost is $50 and you want to buy only 10 shares of a stock selling for $50 per share, you will be paying 10% to buy those shares ($50 X 10 shares = $500 ./. $50 = 10%). If you bought 100 shares, however, your transaction cost of $50 would be only 1%.
Stocks can be purchased in “street name”, which means to hold them in an account in your name , or they can be purchased in certificate form. It is not efficient to hold them in certificate form nowadays, however, so most people open a brokerage account and buy or sell their stocks in an account that is titled in their name. It is faster, safer and far less complicated to own stocks in an account than owning stock in certificate form.
Stocks are bought and sold worldwide through trading places called “exchanges”, in all types of currencies, day and night, continuously. There is a vigorous and busy marketplace for stocks all around the globe. There are quite a few exchanges: several in the US including New York (the largest, Canada, London, Germany, France, several in Asia and South America, some in Eastern Europe, Australia, Africa and the Middle East. Stocks are bought and sold all over the world, day in and day out.
U.S. Stock markets are regulated by the federal government, with stock brokers and investment firms regulated by the states as well. There are many rules and regulations, too many to explain here, but most of the rules exist to prevent abuse of investors, keep the markets orderly and provide a structure that allows corporations to raise money legally. These rules and regulations have grown considerably in scope over the last 60-70 years, sometimes in response to a negative event or fraudulent behavior of an individual, but also because of technology, changes in investments and changes in the investing population. The stock market, with the rules and regulations that govern it, is an ever-changing part of the economic engine that drives the US on towards growth, prosperity and financial strength.
Deciding what stocks you want to own is a complex task that requires careful analysis and expertise. The basic rule is to choose the kind of stocks that have the most potential to produce the result that matches your financial goals. In addition, it is important to choose the very best quality of stocks that you can afford, but for many investors, this is often not easy to determine. The basic reasons for owning stocks for most people are that stocks tend to grow in value over time, outpacing inflation over long periods of time, are easy to own, pay dividends and are liquid, not requiring the investor to lock in for a specific period of time. Historically, stocks have outperformed bonds but selecting good stocks is key to getting this result.The bottom line is that getting objective, professional advice is often the best thing to do if you intend to buy and own stock.
For most Americans, the best way to own stocks is in a mutual fund. The advantages of mutual funds are significant, and will be explained in more detail in the next article.
The next article will be on mutual funds, so stay tuned in and see how much you can learn!
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©2013 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only.
Mary Lynne Dahl©2013