Stocks, Bonds, and Mutual Funds — The Basics

There are no “hot tips” here, but rather an attempt to introduce you to the world of investing, and give a springboard for further development. First, the requisite disclaimer: this writer is not a “Certified Financial Planner” nor does he have any educational degree relevant to financial planning. In another section you will find personal stories that give some background, but when investing it is always important to get as much information as possible on proposed investments, from as many different resources as possible – “due diligence”.  Always add to this common sense and a reasonable dose of skepticism.

When you are investing in stocks, bonds and mutual funds, you are investing in business, in commerce. The exception, of course, is government bonds, but even there the resemblance to business is sufficient to lump them together for our discussion.

Always the first question to ask is, “what is the risk”? If you give someone else your money, what are the chances that you will get it back, and with a profit? If you buy a stock, you become part owner of a company. If the company does well, perhaps you can sell your stock for more than you paid for it, and your investment will have been worthwhile. Perhaps while you own it, the company management will decide to share profits with the shareholders, and pay a dividend, usually a worthy (but not a necessary) feature of stock ownership. If dividends are paid, they may be paid every three months (quarterly) or every month, or only annually. But you may find that, whether or not the company pays a dividend, at any given time, nobody else is willing to pay the amount you paid for your stock – you can’t sell it for what you paid for it. This is risk, the downside versus the possible rewards on the upside. And of course don’t expect your brokerage to insulate you from any such losses, they are merely intermediaries (in most cases) and your agreement with them clearly says, in the fine print, you are responsible for your own gains or losses.

BONDS

MUTUAL FUNDS

COMMON STOCKS

PREFERRED STOCKS

STOCK RIGHTS

STOCK WARRANTS

Bonds are a somewhat different animal. The company issuing the bonds is borrowing money from you, and promising to repay the amount borrowed, with a certain amount of interest paid to you in some stated way. If you see the stock market moving down, you might think it a good thing to have a promised repayment, plus a “guaranteed” interest payment. But there are several kinds of risks with bonds. First, the stability of the company—well, General Motors is not likely to go bankrupt, is it? Or would Enron? Second, while your money is on loan in a bond, the stock market might go up quite a bit, and you risk missing better returns. Third, while your money is tied up—you put a hundred dollars in a bond, a year later you’ll be getting a hundred back, with some interest, say five dollars– in that year, inflation may have made the purchasing power of that hundred and five worth much less that it was at the beginning of the year. So bonds bear their own form of risk. You can see that government bonds, while not likely to suffer bankruptcy, would still have the latter forms of risks, as would bank certificates of deposit.

MUTUAL FUNDS

Mutual funds provide a convenient way of investing in shares of a variety of businesses. As such, they provide a bit of “padding” around the risk of an individual stock (or bond, in the case of bond funds), but they can and do vary in value as the stock market moves up and down. Index funds, of course, generally move with the market index they model. Other mutual funds are managed to attempt to make money regardless of the overall market, and some do more or less succeed in that. But every fund, in its prospectus as it shows its past results, includes a statement to the effect that “past performance does not guarantee future results”, and every investor should take that statement to heart, even as he closely examines an investment’s history.

COMMON STOCKS

When you purchase common stocks, generally you may expect the purchase to come with the right to vote on matters the issuing company’s board wishes to bring before the stockholders at its annual, or at a specially called, meeting. You may receive dividends, if the board decides to issue them. The board is always balancing the use of profits between rewarding stockholders with dividends or reinvesting for growth of the company, so low or no dividends may be either a bad thing or a good thing for the company.

You have the right to sell the stock. That is, you have liquidity in your investment. But you have no guarantee that you can sell the stock for the amount you paid for it.

You have residual rights. If the company is dissolved, after all creditors are satisfied, any remaining value may be distributed to the shareholders of common stock – but you’re last in line.

PREFERRED STOCKS

A company may issue one or more types of preferred stocks, usually paying an attractive dividend. These stocks sell more or less at a par value, often a hundred dollars a share, but maybe twenty-five or fifty dollars. After issue, the market will determine the exact dollar value. Most are callable. At a set date, or perhaps after a grace period (usually five years) the issuing company can call them back in, giving the holder the stock’s par value. This may result in some capital gains or losses, but you usually pay close enough to par value that capital gains may not be too significant. There may be special cases where this is not true, so always try to be aware of any other circumstances that might influence a high discount to par value when you are purchasing a preferred stock.

Dividends are set as a percent of par value, and the preferred dividend must be paid in full before any dividend can be paid to the holders of common stock. For most issues, dividends are cumulative. This means if a dividend is missed, it is still owed to the preferred stockholder, and must be paid as soon as the company is able to do so, whereas for the holder of common stock, if a dividend is missed, it’s just too bad.

Some preferred issues are convertible to common stock. Because (if the common stock price goes up) this could be a real benefit, the dividend probably will be lower than would be the case for a straight preferred issue.

STOCK RIGHTS

Purchasing a common stock may or may not include certain rights, such as the right to buy any new issue of stock at a set price, usually under the market price. This right may be only for a brief period of time (one month, perhaps) after the new issue.

STOCK WARRANTS

Warrants give the right to buy stock at a fixed price for a period (perhaps ten years or more). This is usually a higher price than the stock is selling for at the time of the warrant issue, so if the stock doesn’t go up it’s not a good deal, but if the stock price does go up substantially, the warrant holder could buy at the warrant price and sell at the market price for a capital gains profit.

<br>Where to go from here? Scan the annotations in the <a href=”http://www.whystudymoney.com/index.php/weblog/category/Reference%20Library/” title=”Reference Library”><b><u>Reference Library</u></b></a> category of this site, and look for books such as these in your local library.

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