Thursday, August 9, 2012

Stocks, bonds, derivatives, oh my!

Today, there are dozens of types of financial instruments employed, ranging from debt securities to derivatives. However, by far the most common are stocks and bonds. These two form the staples of any investor's portfolio, both an individual's and an institution's. By Amdahl's law, the bulk of one's time should be spent understanding how these two securities operate and studying how to maximize returns in these two areas.

Bonds

Bonds are essentially loans given to a company as a way for them to raise both short term and long term funds. You pay a certain amount of money up front, called the principal, in return for regular interest payments. When the bond term ends, known as reaching maturity, the principal will be returned to you in full.

U.S. Steel Corporation bond
The interest rate, called the coupon, is fixed throughout the lifetime of the bond and is typically paid either annually or semi-annually (every 6 months). Short-term maturities (1-5 years) are safer and thus have lower coupon rates than longer-term maturities (10-30 years).

The terms of the bond generally lead people to believe that they are a safe investment, as the company promises a positive return on your money. However, promises are not always honored. You must realize that the principal amount you give them will not be idling in a savings account. Instead it will be used to fund their own business, and as with any business, it can be prone to failure. In the event of a bankruptcy, bondholders may end up losing some or all of the principal amount (and all future interest payments).

Stocks

Stocks are fundamentally very different from bonds. Typically when you buy company stock on the stock market, you are not funding the company directly. Instead, you are buying a stake in the company in hopes that the share prices will go up in the future, at which point you can sell at a profit.

Stock price of Wal-Mart (ticker: WMT) the past year
Owning shares of a company's stock is owning a part of that company, in an amount proportional to the number of shares. The total number of shares in the market represents how coarse or fine a company is divided into. If a company X is valued at $1,000,000 with a total of 100,000 shares, each share will cost $10 on the stock market. If I buy 10,000 shares for $100,000, I can claim a 10% ownership of that company.

So why do people buy stock? The reason is fundamentally the same as why people invest money into companies: they believe that the business will grow and will be worth more in the future than what it's worth now. If in 5 years, company X grows to a $1,500,000 business, each share will be worth $15 and any shareholders can sell their shares for a 50% profit.

Many companies also let you partake in part of their profits as a shareholder through dividends. If company X made $100,000 this year, the board of directors may elect to distribute the earnings to it's shareholders. In that case, each shareholder would receive $1 per share owned. However, more likely the company will reinvest the $100,000 back into the business in hopes of generating even greater profits the next year. This would raise the value of the company, causing stock prices to increase, and thus indirectly benefiting shareholders.

The Rest of the Iceberg

If you go beyond the tip, you start entering the world of futures, options, forex, swaps, and more. Even within stocks and bonds, you have preferred stock, mutual funds, floating rate notes, treasury inflation protected securities (TIPS), etc.

There are a lot of possibilities and choices, but thankfully the individual investor need only concern himself with a select few. Future posts will be dedicated to giving a more in-depth analysis of how the bond market and stock market work, how money can be lost and made in these markets, and what you should do to minimize losses and maximize gains.

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Obligatory Disclaimer

The author is not qualified to give financial, tax, or legal advice and disclaims any and all liability for this information.