Stocks, Bonds, and Cash: The Basics
For many people, the world of stocks, bonds, and cash is shrouded in mystery – yet they are the building blocks of most investment portfolios. The following is a layperson's guide to key concepts and terms. You'll be amazed at how uncomplicated they can be
The two basic types of stock are "common" and "preferred." If you own common stock you may vote on such issues as the company's business objectives and board members. Preferred stockholders do not have voting rights, but instead may receive dividends – quarterly payments made from the company's earnings. They also get preferential treatment in the event of a bankruptcy.
Why have them: Stocks are an important part of many people's investment portfolio because they have the greatest potential to make the most amount of money. However, stocks are inherently volatile. One day your stock may be worth more than what you paid for it, the next, less.
Scenario A: Your instinct is correct! The next time you check the price of your stock, it is being offered at $7 per share. Your $500 investment is now worth $700 – a two hundred dollar increase! You can either sell your shares and walk away with the profit, or, if you think it will increase even further, hold on to them.
Scenario B: Scandal rocks HDC – the president was caught embezzling millions of dollars and is now facing prison time. The stock price plummets to $1 a share. Your $500 investment is now worth $100. You can either sell your shares and at least recoup a hundred dollars, or, if you think the company will eventually recover, keep them.
As bonds are frequently bought and sold before they mature, investing in them can be very complex. Most beginning investors will stick to the "buy and hold" method.
Why have them: Bonds are considered a fixed income investment, and so compliment the more volatile nature of many stocks. As a general rule, when the stock market performs poorly, bonds do well. And in the event of bankruptcy, bondholders are paid in full before stockholders. There are also tax advantages to some bonds, such as those issued by municipalities ("muni" bonds), where gains are not subject to federal income tax.
Scenario B: ABC Pharmaceuticals has just discovered a potential new cancer treatment. Needing money for the final stage of research, they issue ten-year bonds. The coupon is twelve percent. You buy a $1000 bond. Unfortunately, another company gains FDA approval for their cancer drug first, causing ABC to go bankrupt. Because you are a bondholder, you receive your $1000 investment back, but not the promised interest rate.
Why have them: Having a portion of your savings in cash is a security measure. Not suitable for long-term growth, they are used to offset the risk of stocks and bonds.
Scenario B: Looking for the safest investment with the best interest rate, you purchase a CD – three months to six-year loans to financial institutions. The longer the CD, the higher the interest. Though FDIC insured, early withdrawals are subject to penalties.
Scenario C: Seeking liquidity as well as safety, you put some of your capital into a money market account. It is FDIC insured and withdrawals are penalty free. Similar to a savings account, it has slightly higher interest rates but fewer allowed transactions.
Scenario D: Wanting liquidity but better return then a money market account, you invest in a money market fund. You can choose the taxable, but higher interest funds that invest in corporate and government debt, or tax free but lower interest funds that invest in municipal debt. Though not FDIC insured, your withdrawals are penalty free, as long as they are for a minimum amount.
|Copyright © 2005 CCCS of San Francisco|