Understanding Stocks

Stocks are a representation of partial ownership in a company. Purchasing stocks means you have purchased a minute portion of the company or shares. The more shares you purchase, the more you own of the company.

If you purchased 50 shares for $50 each, you have made an investment of $2,500. If the company performed well for several years, as a partial owner you would succeed as well. Your shares will increase in value along with the company.

If the performance of the company is poor, your shares will decrease in value. If you sell before the value increases, you will take a loss. Stocks are also referred to as:

There are several reasons a company issues shares for the public. The most common reason is to raise enough cash for the future growth of the business. There are several prominent stock exchanges in the United States including:

Nasdaq:

Nasdaq is an electronic global exchange providing securities lists for smaller capitalization companies all over the world. The majority of the index consists of financial and technology stock with the following also included.

The basis of the sector for United States technology is formed by the sector index and benchmark.

New York Stock Exchange:

NYSE or the New York Stock Exchange is the world's largest exchange. The basis is the market cap of the securities listed. The majority of the largest and oldest companies are listed.

The NYSE has experienced numerous mergers. In 2013, it was purchased by ICE or the Intercontinental Exchange. The DJIA or Dow Jones Industrial Average consists of thirty of the largest companies.

One of the most-watched and oldest indexes on the globe is the NYSE.

American Stock Exchange:

AMEX or the American Stock Exchange was acquired in 2017 by the NYSE Euronext and became NYSE American. It was originally known for introducing new asset classes and products and for trading.

ETFs were first introduced by this exchange which operates electronically and consists mainly of small-cap stocks.

The SEC or United States Securities and Exchange Commission regulates all of these markets.

Understanding Bonds

Since a bond is essentially a loan from you to a government or company, you do not purchase any shares and no equity is involved. When you purchase a bond, the government or company is in debt to you.

You receive interest for a set period of time for the loan. You will then be paid back in full for the purchase price of the bond. There are still risks in purchasing bonds. If the company declares bankruptcy, you no longer receive interest payments.

Your full principal may not be returned either. A good example is purchasing a bond for 10 years with two percent annual interest for $2,500. You would receive interest payments of $50 evenly distributed each year.

When the 10 years ends, your interest earned would total $500. You also receive your initial $2,500 investment back as well. When you hold your bond for the complete duration it is referred to as holding until maturity.

When you purchase bonds, you specifically know what you have signed up for. You can use your interest payments as a predictable fixed income for a long period of time. The type of bond you purchase determines the duration.

The duration range for the majority of bonds is between a few days and 30 years. Your yield or interest rate varies according to the duration and type of bond you purchased.

There are three key groups or participants in the bond market. These are issuers, underwriters and participants.

Issuers:

Issuers are the entities developing, registering and selling instruments through the bond market. This can be different government levels or corporations. A good example is the Treasury bonds issued by the United States government.

These long-term securities mature in 10 years and offer investors interest payments bi-annually. When you make an investment in specific bond market sectors including United States Treasury securities, your risk is lower than stock market investments.

This is because the volatility of the stock market is higher than within the bond market.

Underwriters:

Underwriters are responsible for evaluating financial risks. An underwriter in the bond market purchases securities from issuers then resells them in order to earn a profit.

Participants:

Participants are the entities purchasing and selling securities and bonds. When bonds are purchased, a loan is issued by the participant for the duration of the security. In return, the participant receives interest.

Once the bond has matured, the participant pays back the bond's face value.

Stocks vs. Bonds

Although both stocks and bonds can increase your investment, the method and the way you receive returns are completely different.

Debt vs. Equity

When you hear the term debt and equity markets, it is generally a referral to stocks and bonds. Equity is the most popular investment you can convert into cash easily. This is referred to as a liquid financial asset.

In 2018 in the United States alone, the country issued more than $221 billion in equity. Equity is often issued by corporations to expand operations and raise money. In return, the investors are able to benefit from the company's future success.

When you purchase bonds, you have issued a debt you are required to pay with interest. You do not acquire an ownership stake in the business. Instead, you have entered into an agreement with the government or company.

You are then required to pay fixed interest and the principal bond amount when the period concludes.

Fixed Income vs. Capital Gains

Cash is generated differently with stocks and bonds. To earn a profit purchasing stock, you must sell your shares in the company for more money than your purchase price. You can then generate a capital gain or profit.

You can reinvest your capital gains or use them for income. Your capital gains will be taxed for either the short-term or the long-term. Cash is generated by bonds with regular interest payments.

The frequency of distribution varies but is usually as follows.

You can also earn a capital gain by selling bonds on the market. If you are a conservative investor, you may find the most attractive feature the predictable fixed income.

The fixed income offered by specific types of stocks is similar to debt as opposed to equity. In most instances, this is not the source of the value of your stocks.

Inverse Relationship

Another difference between bonds and stocks is they generally have an inverse relationship regarding price. When the price of bonds increases, stock prices decrease and vice versa.

Throughout the course of history, when the price of stocks is increasing, more investors make purchases for growth capitalization while bond prices generally decrease due to lower demand.

This means when stock prices decrease, many investors look towards traditional lower-return and lower-risk investments. This increases the demand and eventually the prices.

The performance of bonds is closely linked to interest rates, A good example is purchasing a bond with a two percent yield. If interest rates decrease, your bond can increase in value.

This is because the yield for a newly issued bond is lower than yours. If the interest rates are higher, the yield for a newly issued bond can be higher than yours. This decreases the demand and value for your bond.

The Federal Reserve usually stimulates spending by cutting interest rates when there is an economic downturn. This period of time is generally worse for the majority of stocks.

Lower interest rates increase the value of your existing bonds to reinforce the inverse price dynamic.

Bond Risks

United States Treasury bonds usually offer more short-term stability than stocks. The lower risk generally means lower returns. Treasury securities including government bills and bonds are nearly risk-free.

This is because the United States government backs all of these instruments. Corporate bonds are different since the risk and return levels vary widely. If the risk of a company declaring bankruptcy is higher, they are unable to pay interest.

This means the risk level is higher for these bonds than for a company with a low risk for bankruptcy. You can determine the ability of a company to pay back its debt by looking at the credit rating.

Agencies including Standard & Poor’s and Moody's assign the credit ratings. Corporate bonds are often categorized into two groups, high-yield bonds and investment-grade bonds.

High-yield or junk bonds have a lower credit rating, higher returns and a higher risk. The different degrees of returns and risk help investors decide which types of bonds to invest in.

This is referred to as building your investment portfolio. According to many financial planners, the distinct roles of bonds often provide the best results since they complement one another.

The general rule regarding investing in bonds is if you are interested in receiving a higher return, you should invest in equities more instead of purchasing fixed-income and riskier investments.

The main role of a portfolio with fixed income is diversification from stocks to preserve your capital as opposed to trying to achieve the highest possible returns.

Stock Risks

A decreasing value share after purchase is the main risk of purchasing stocks. There are many different reasons for the fluctuation of stock prices. The main reason is when the performance of the company does not meet investor expectations.

In this instance, the price of the stock can decrease. Due to the wide range of reasons for the potential decline of any company, investing in stocks is generally riskier than bonds.

The good news is when you take a higher risk, you can receive higher returns, The S&P in 2020 had a 10.65 percent average annual return for 10 years. The total return of the United States bond market is 3.92 percent for 10 years.

Portfolio Allocation for Stocks and Bonds

You will hear a wide range of advice regarding the best way to allocate bonds and stocks for your portfolio. Some investors believe the stocks and bonds percentage for your portfolio should be 100 after deducting your age.

This means if you are 30 years of age, your portfolio should consist of 70 percent stocks and 30 percent bonds. If you have reached the age of 60, the percentages change to 40 percent stocks and 60 percent bonds. This percentage is logical.

As you near retirement, you are protecting your savings from wild swings in the market by filling your portfolio with more bonds and fewer stocks. Other investors believe this theory is far too conservative.

The reason is the modern lifespan is longer and low-cost indexes have become prevalent. This is a much easier and cheaper type of diversification generating less risk than purchasing individual stocks.

Another argument states 110 or 120 minus your current age is more appropriate in the modern world. The majority of investors equate allocating stocks and bonds with risk tolerance.

You need to determine the amount of volatility you feel comfortable with in return for better gains over the long term. A study was conducted consisting of data beginning in 1926 and ending in 2019.

The idea was to determine how different allocations would have performed during this period in time. The data was used to determine risk tolerance and timelines for the best possible allocation.

We want you to realize the annual averages do not generally reflect any specific year. A good example is in 2008, the S&P was down 37 percent when finished. By the close of 2009, 26.46 percent was regained and partially offset the losses from 2008.

This is something you should consider before allocating your portfolio. If your portfolio consists of 100 percent stocks, your year is twice as likely to conclude with a loss in comparison to a portfolio of 100 percent bonds.

You need to decide if a higher return for the long term is worth risking these types of downturns in addition to your timeline. You can purchase specific types of stocks with the same benefits as fixed-income bonds.

These types of bonds are similar to the higher-return and higher-risk nature of many stocks.

Preferred Stock and Dividends

Most dividend stocks are issued by stable and large companies generating high profits on a regular basis. These profits are often distributed to shareholders as dividends as opposed to investing them in the growth of the company.

Since these companies do not usually target aggressive growth, the price of the stocks might not increase as fast or high as a smaller company. If you are interested in the diversification of your fixed-income assets, these dividend payments have value.

Preferred stocks are very similar to bonds. They are usually classified as fixed-income investments with a higher risk than bonds but lower than common stocks. The dividends you receive from preferred stocks are usually higher.

Selling Bonds

If the value of your bonds is higher than your initial purchase price, you can sell them for capital gains on the market. This is possible due to a better rating from credit agencies, interest rate changes or both.

You may defeat your purpose in making investments if you purchase risky bonds to gain higher returns, preserve capital, diversify from equities or provide a cushion when the market drops quickly.