Stocks
To raise money to operate and expand a company, its owners will often sell part of the company. A company that wants to raise money this way must first organize itself as a legal corporation. At that time, it creates shares of stock, which are small units of ownership in the company. Shares of stock are bought and owned by shareholders, who have the right to attend shareholder meetings, inspect corporate documents, and vote on certain matters that affect the company. Shareholders also may have preemptive rights, which means they are able to buy new shares before they are offered to the public so that existing shareholders can maintain their percentage of ownership in a company.
Not all corporations offer their shares for sale to the public. When a company chooses to do so, its first sale of shares is called an initial public offering (IPO). IPO stock is purchased by investors at a price set by the company. The money paid for each share of stock is then available to the company for its business operations. In return, shareholders can receive benefits in two forms: dividends and appreciation. Dividends are a portion of the company's profits distributed to shareholders. Not all companies that issue stock pay dividends. Those that do usually pay them every quarter (a quarter is three consecutive months of the year; there are four quarters in a fiscal year), and, while each share of stock might earn only a few pennies for every share of stock owned, the amounts paid in dividends to large individual or institutional investors can be enormous. Appreciation is a gradual increase in the value of a share over time. If a corporation prospers then a shareholder can sell his share to someone else for a higher price than he originally paid for it. There is no guarantee that a stock will appreciate, however; it is quite possible it will depreciate (decrease in value) over time instead.
TYPES OF SHAREHOLDERS. Corporations can offer different types of shares, called either common or preferred shares, with each type providing the shareholder a different set of rights. According to Ameritrade (http://www.ameritrade.com/educationv2/fhtml/stocksfunds/prevscom), owners of common stock shares can be paid dividends in cash, property, or more stock. Cash dividends are investment earnings that are paid to the shareholder in the form of cash; they are taxed in the year in which they are paid out by a corporation to the shareholder. Property dividends are earnings usually paid in the form of the issuing company's products or services. Stock dividends are earnings paid in more shares of a company's stock. Although cash dividends are the stock earning most often issued to common shareholders, a corporation may decide to stop paying dividends on a temporary basis if the company is experiencing financial instability. Additionally, if a company files for bankruptcy, owners of common stock are the last to be paid, after all creditors and owners of preferred stock. Common stock shareholders, however, do have certain rights within a company, such as the right to vote for board members and officers, which preferred stock owners do not.
Preferred stock shareholders do earn guaranteed dividends, though, the values of which are set in advance and pay indefinitely unless the stock is retired or recalled. There are four different kinds of preferred stock. Cumulative preferred stock accumulates whether or not a company has suspended paying dividends, and the preferred shareholder is paid the accumulated earnings once the company begins paying dividends again. Cumulative preferred stock owners receive their dividends before common stock owners receive theirs. Noncumulative preferred stock does not accumulate over temporary dividend suspensions, and its owners do not receive dividend earnings before common stock shareholders. Participating preferred stocks allow shareholders to earn additional dividends when a company's profits exceed expectations. Convertible preferred stock can be changed into common stock if its owner wants to take advantage of common stock appreciation.
Although both common and preferred shareholders can lose the money that they paid for their shares, as well as whatever money the shares may have earned since the initial purchase, they have what is called "limited liability," meaning they cannot be held financially responsible for any lawsuits filed against the company. This limited liability is one of the most important characteristics of stock ownership. Without limited liability, people would not want to become part-owners of the corporation, and the corporation would therefore have trouble raising the money it needs to operate and expand.
PRICING SHARES. When a corporation creates shares, it determines the price per share for the initial public offering. From then on the price of each share depends on the public's perception of how well the corporation is doing. The more profit a corporation makes, the higher the price per share is likely to be. The challenge for investors, of course, is that shareholders cannot predict the future, and stock prices have a tendency to fluctuate up and down over time. A variety of events can influence a stock's price, from the release of a popular new product to news that a company's CEO (chief executive officer) is being investigated for fraud.
The market for stocks sold by shareholders to other shareholders is called the secondary stock market. It would be almost impossible for all shareholders to find buyers for their shares on their own when they choose to sell. To make it easier for shareholders to buy and sell shares, companies affiliate with a particular stock exchange that handles share transactions. In the United States the two most prominent exchanges are the New York Stock Exchange (NYSE) and the NASDAQ (originally known as the National Association of Securities Dealers Automated Quotations, but now called by its acronym). The NYSE and NASDAQ are themselves publicly traded companies. The United States also hosts the American Stock Exchange, Boston Stock Exchange, Chicago Stock Exchange, Pacific Exchange in San Francisco, and the Philadelphia Stock Exchange. Additionally, there are stock exchanges in most countries throughout the world.
Bonds
Another way for a company to raise money is to borrow it. Companies can borrow from banks, just like individuals, but they can also borrow by issuing bonds, which are written promises to pay the bondholder back with interest. Bonds have a face value, called par, and that amount defines the amount of the debt.
A bond offers returns to holders in two ways. The organization that issued the bond pays interest to the holder, and the holder can redeem the bond after a certain period of time. That is, the holder can sell the bond back to the organization for its face value. The issuing organization will either make regular interest payments on the bond or initially sell the bond at a much lower price than the face value. After a certain amount of time (often many years), the holder can redeem the bond for face value.
Bonds differ from shares of stock in several important respects. First, any organization can issue bonds, whereas only corporations can issue stock. For that reason, unincorporated businesses and federal, state, and local governments use bonds to raise money. Second, bonds provide no ownership interest in the company. The organization's only obligation to the bondholder is to pay the debt and interest. Bonds are usually less risky for the purchaser than stocks, because the organization is legally obligated to pay the debt, whereas if a corporation has financial difficulties, it is not permitted to pay anything to shareholders until it has paid off its creditors. However, the rate of return on investment for stocks is generally higher than on bonds to compensate for the higher risk factor. Like stocks, though, bonds are traded by investors for prices that may be very different from the par value. Investors who buy bonds are buying the right to receive the interest payments and to redeem the bond.
The price of a bond depends on a number of factors, including the organization's creditworthiness and the interest rate. Generally, the better the organization's credit rating, the higher the price of the bond. If the organization begins to have financial problems that could impact its ability to repay the bonds, the price of those bonds will go down. One of the best-known rating companies for bonds is Standard and Poor's, which rates issuing organizations on a scale ranging from AAA to D.
Bonds may be short-term or long-term. Long-term bonds are riskier than short-term, and therefore tend to pay higher interest rates. For investors, the safest type of bond is called a T-bill, which is a short-term bond issued by the U.S. Treasury. Investors are very unlikely to lose money on T-bills. As a result, the interest rate of T-bills is low, but investors know that their investment is safe.
Table 4.1 provides historical information on bond yields and interest rates.
Mutual Funds
Most investors try to diversify investments; that is, they put money into a number of different types of investments rather than just one or two (a person's total investments are called his or her portfolio). That way, even if one investment loses money, another may make enough profit to compensate for the loss.
For small investors, however, it can be difficult to diversify. It takes time to evaluate different investments, and small investors may only be able to afford to buy one or two shares of each stock. Most brokers have a minimum purchase requirement higher than what the average investor can afford. Mutual funds were developed to solve such problems for small investors. In a mutual fund the money of investors is pooled and then invested in stocks, bonds, or both. The managers of the mutual fund then buy and sell the stocks and bonds on behalf of the investors. By combining their money, small investors are able to diversify.
Unlike the prices of stocks and bonds, the price of a mutual fund is determined by the fund manager rather than by the open market. This price, called net asset value, is based on the fund manager's estimation of the fund's value at a particular time. Mutual funds may be purchased either directly from the fund manager or through a broker or other intermediary. The latter is more expensive, because the investor will be required to pay fees. Mutual funds provide income to investors in two ways. First, if the mutual fund sells stocks or bonds at a profit or receives dividends or interest payments on bonds, these gains can be paid to investors as distributions. Second, the price of the mutual fund itself may go up, in which case investors can sell their mutual funds for more than they paid.
Some people are willing to take a fair amount of risk when they invest, hoping that they will make more money. Usually, the riskier the investment is, the higher the potential return on it is. Others would rather get a smaller return but know that their money is invested in a safer vehicle.
FIGURE 4.1
Different types of mutual funds have developed to meet the needs of these different types of investors. (See Figure 4.1.) Mutual funds differ just as investors do in how much risk they want to take. Some mutual funds invest more conservatively than others. The safest type of mutual fund—and the one that pays the lowest interest—is a money-market fund, which invests in short-term bonds such as T-bills.
Commodities
The term commodity, in the narrow sense used here, means a contract to buy or sell something that will be available in the future. (In a broader sense, anything that can be bought or sold is a commodity.) These sorts of agreements are traded in commodities exchanges. Two important exchanges in the United States are the Chicago Board of Trade and the Kansas City Board of Trade.
There are two basic types of commodities. Futures are standardized contracts in which the seller promises to deliver a particular good to the buyer at a specified time in the future, at which point the buyer will pay the seller the price called for in the contract. Options on futures (which are usually simply called options) are more complicated. Depending on their exact terms, they establish the right of the buyer of the option to either buy or sell a futures contract for a specified price. Options that establish the right to buy a futures contract are "call options." Those that establish the right to sell a futures contract are "put options." In either case, the buyer of the option only has a limited time in which he can exercise his right, but he is also free not to exercise the right at all.
The meaning of a commodities contract has been changing. Raw materials and agricultural commodities
TABLE 4.1
| Bond yields and interest rates, 1900–2002 | ||||||||
| [Percent per year. Annual averages of either daily or monthly figures, except as indicated] | ||||||||
| Year | U.S. Treasury securities 3 month bills (new issues) | Corporate bonds (Moody's) Aaa | Corporate bonds (Moody's) Baa | High grade municipal bonds (Standard & Poors) | New home mortgage yields | Prime rate charged by banks | Discount rate, Federal Reserve Bank of New York | Federal funds rate |
| 1900 | NA | NA | NA | 3.12 | NA | NA | NA | NA |
| 1901 | NA | NA | NA | 3.13 | NA | NA | NA | NA |
| 1902 | NA | NA | NA | 3.20 | NA | NA | NA | NA |
| 1903 | NA | NA | NA | 3.38 | NA | NA | NA | NA |
| 1904 | NA | NA | NA | 3.45 | NA | NA | NA | NA |
| 1905 | NA | NA | NA | 3.40 | NA | NA | NA | NA |
| 1906 | NA | NA | NA | 3.57 | NA | NA | NA | NA |
| 1907 | NA | NA | NA | 3.86 | NA | NA | NA | NA |
| 1908 | NA | NA | NA | 3.93 | NA | NA | NA | NA |
| 1909 | NA | NA | NA | 3.78 | NA | NA | NA | NA |
| 1910 | NA | NA | NA | 3.97 | NA | NA | NA | NA |
| 1911 | NA | NA | NA | 3.98 | NA | NA | NA | NA |
| 1912 | NA | NA | NA | 4.02 | NA | NA | NA | NA |
| 1913 | NA | NA | NA | 4.22 | NA | NA | NA | NA |
| 1914 | NA | NA | NA | 4.12 | NA | NA | NA | NA |
| 1915 | NA | NA | NA | 4.16 | NA | NA | NA | NA |
| 1916 | NA | NA | NA | 3.94 | NA | NA | NA | NA |
| 1917 | NA | NA | NA | 4.20 | NA | NA | NA | NA |
| 1918 | NA | NA | NA | 4.50 | NA | NA | NA | NA |
| 1919 | NA | 5.49 | NA | 4.46 | NA | NA | NA | NA |
| 1920 | 5.42 | 6.12 | NA | 4.98 | NA | NA | NA | NA |
| 1921 | 4.83 | 5.97 | NA | 5.09 | NA | NA | NA | NA |
| 1922 | 3.47 | 5.10 | NA | 4.23 | NA | NA | NA | NA |
| 1923 | 3.93 | 5.12 | NA | 4.25 | NA | NA | NA | NA |
| 1924 | 2.77 | 5.00 | NA | 4.20 | NA | NA | NA | NA |
| 1925 | 3.03 | 4.88 | NA | 4.09 | NA | NA | NA | NA |
| 1926 | 3.23 | 4.73 | NA | 4.08 | NA | NA | NA | NA |
| 1927 | 3.10 | 4.57 | NA | 3.98 | NA | NA | NA | NA |
| 1928 | 3.97 | 4.55 | NA | 4.05 | NA | NA | NA | NA |
| 1929 | 4.42 | 4.73 | 5.90 | 4.27 | NA | 5.50–6.00 | 5.16 | NA |
| 1930 | 2.23 | 4.55 | NA | 4.07 | NA | 3.50–6.00 | NA | NA |
| 1931 | 1.40 | 4.58 | NA | 4.01 | NA | 2.75–5.00 | NA | NA |
| 1932 | 0.88 | 5.01 | NA | 4.65 | NA | 3.25–4.00 | NA | NA |
| 1933 | 0.52 | 4.49 | 7.76 | 4.71 | NA | 1.50–4.00 | 2.56 | NA |
| 1934 | 0.26 | 4.00 | NA | 4.03 | NA | 1.50 | NA | NA |
| 1935 | 0.14 | 3.60 | NA | 3.40 | NA | 1.50 | NA | NA |
| 1936 | 0.14 | 3.24 | NA | 3.07 | NA | 1.50 | NA | NA |
| 1937 | 0.45 | 3.26 | NA | 3.10 | NA | 1.50 | NA | NA |
| 1938 | 0.05 | 3.19 | NA | 2.91 | NA | 1.50 | NA | NA |
| 1939 | 0.02 | 3.01 | 4.96 | 2.76 | NA | 1.50 | 1.00 | NA |
| 1940 | 0.01 | 2.84 | 4.75 | 2.50 | NA | 1.50 | 1.00 | NA |
| 1941 | 0.10 | 2.77 | 4.33 | 2.10 | NA | 1.50 | 1.00 | NA |
| 1942 | 0.33 | 2.83 | 4.28 | 2.36 | NA | 1.50 | 1.00 | NA |
| 1943 | 0.37 | 2.73 | 3.91 | 2.06 | NA | 1.50 | 1.00 | NA |
| 1944 | 0.38 | 2.72 | 3.61 | 1.86 | NA | 1.50 | 1.00 | NA |
| 1945 | 0.38 | 2.62 | 3.29 | 1.67 | NA | 1.50 | 1.00 | NA |
| 1946 | 0.38 | 2.53 | 3.05 | 1.64 | NA | 1.50 | 1.00 | NA |
| 1947 | 0.59 | 2.61 | 3.24 | 2.01 | NA | 1.50–1.75 | 1.00 | NA |
| 1948 | 1.04 | 2.82 | 3.47 | 2.40 | NA | 1.75–2.00 | 1.34 | NA |
| 1949 | 1.10 | 2.66 | 3.42 | 2.21 | NA | 2.00 | 1.50 | NA |
| 1950 | 1.22 | 2.62 | 3.24 | 1.98 | NA | 2.07 | 1.59 | NA |
| 1951 | 1.55 | 2.86 | 3.41 | 2.00 | NA | 2.56 | 1.75 | NA |
| 1952 | 1.77 | 2.96 | 3.52 | 2.19 | NA | 3.00 | 1.75 | NA |
| 1953 | 1.93 | 3.20 | 3.74 | 2.72 | NA | 3.17 | 1.99 | NA |
| 1954 | 0.95 | 2.90 | 3.51 | 2.37 | NA | 3.05 | 1.60 | NA |
| 1955 | 1.75 | 3.06 | 3.53 | 2.53 | NA | 3.16 | 1.89 | 1.78 |
| 1956 | 2.66 | 3.36 | 3.88 | 2.93 | NA | 3.77 | 2.77 | 2.73 |
| 1957 | 3.27 | 3.89 | 4.71 | 3.60 | NA | 4.20 | 3.12 | 3.11 |
| 1958 | 1.84 | 3.79 | 4.73 | 3.56 | NA | 3.83 | 2.15 | 1.57 |
| 1959 | 3.41 | 4.38 | 5.05 | 3.95 | NA | 4.48 | 3.36 | 3.30 |
| 1960 | 2.93 | 4.41 | 5.19 | 3.73 | NA | 4.82 | 3.53 | 3.22 |
| 1961 | 2.38 | 4.35 | 5.08 | 3.46 | NA | 4.50 | 3.00 | 1.96 |
| 1962 | 2.78 | 4.33 | 5.02 | 3.18 | NA | 4.50 | 3.00 | 2.68 |
| 1963 | 3.16 | 4.26 | 4.86 | 3.23 | 5.89 | 4.50 | 3.23 | 3.18 |
| 1964 | 3.55 | 4.40 | 4.83 | 3.22 | 5.83 | 4.50 | 3.55 | 3.50 |
| 1965 | 3.95 | 4.49 | 4.87 | 3.27 | 5.81 | 4.54 | 4.04 | 4.07 |
| 1966 | 4.88 | 5.13 | 5.67 | 3.82 | 6.25 | 5.63 | 4.50 | 5.11 |
| 1967 | 4.32 | 5.51 | 6.23 | 3.98 | 6.46 | 5.61 | 4.19 | 4.22 |
| NA Not available. | ||||||||
| SOURCE: "No. HS-39. Bond Yields and Interest Rates: 1900 to 2002," in Statistical Abstract of the United States: 2003, U.S. Census Bureau, http://www.census.gov/statab/hist/HS-39.pdf (accessed January 4, 2005) | ||||||||
| 1968 | 5.34 | 6.18 | 6.94 | 4.51 | 6.97 | 6.30 | 5.16 | 5.66 |
| 1969 | 6.68 | 7.03 | 7.81 | 5.81 | 7.81 | 7.96 | 5.87 | 8.20 |
| 1970 | 6.46 | 8.04 | 9.11 | 6.51 | 8.45 | 7.91 | 5.95 | 7.18 |
| 1971 | 4.35 | 7.39 | 8.56 | 5.70 | 7.74 | 5.72 | 4.88 | 4.66 |
| 1972 | 4.07 | 7.21 | 8.16 | 5.27 | 7.60 | 5.25 | 4.50 | 4.43 |
| 1973 | 7.04 | 7.44 | 8.24 | 5.18 | 7.96 | 8.03 | 6.44 | 8.73 |
| 1974 | 7.89 | 8.57 | 9.50 | 6.09 | 8.92 | 10.81 | 7.83 | 10.50 |
| 1975 | 5.84 | 8.83 | 10.61 | 6.89 | 9.00 | 7.86 | 6.25 | 5.82 |
| 1976 | 4.99 | 8.43 | 9.75 | 6.49 | 9.00 | 6.84 | 5.50 | 5.04 |
| 1977 | 5.27 | 8.02 | 8.97 | 5.56 | 9.02 | 6.83 | 5.46 | 5.54 |
| 1978 | 7.22 | 8.73 | 9.49 | 5.90 | 9.56 | 9.06 | 7.46 | 7.93 |
| 1979 | 10.04 | 9.63 | 10.69 | 6.39 | 10.78 | 12.67 | 10.28 | 11.19 |
| 1980 | 11.51 | 11.94 | 13.67 | 8.51 | 12.66 | 15.27 | 11.77 | 13.35 |
| 1981 | 14.03 | 14.17 | 16.04 | 11.23 | 14.70 | 18.87 | 13.42 | 16.38 |
| 1982 | 10.69 | 13.79 | 16.11 | 11.57 | 15.14 | 14.86 | 11.02 | 12.26 |
| 1983 | 8.63 | 12.04 | 13.55 | 9.47 | 12.57 | 10.79 | 8.50 | 9.09 |
| 1984 | 9.58 | 12.71 | 14.19 | 10.15 | 12.38 | 12.04 | 8.80 | 10.23 |
| 1985 | 7.48 | 11.37 | 12.72 | 9.18 | 11.55 | 9.93 | 7.69 | 8.10 |
| 1986 | 5.98 | 9.02 | 10.39 | 7.38 | 10.17 | 8.33 | 6.33 | 6.81 |
| 1987 | 5.82 | 9.38 | 10.58 | 7.73 | 9.31 | 8.21 | 5.66 | 6.66 |
| 1988 | 6.69 | 9.71 | 10.83 | 7.76 | 9.19 | 9.32 | 6.20 | 7.57 |
| 1989 | 8.12 | 9.26 | 10.18 | 7.24 | 10.13 | 10.87 | 6.93 | 9.21 |
| 1990 | 7.51 | 9.32 | 10.36 | 7.25 | 10.05 | 10.01 | 6.98 | 8.10 |
| 1991 | 5.42 | 8.77 | 9.80 | 6.89 | 9.32 | 8.46 | 5.45 | 5.69 |
| 1992 | 3.45 | 8.14 | 8.98 | 6.41 | 8.24 | 6.25 | 3.25 | 3.52 |
| 1993 | 3.02 | 7.22 | 7.93 | 5.63 | 7.20 | 6.00 | 3.00 | 3.02 |
| 1994 | 4.29 | 7.96 | 8.62 | 6.19 | 7.49 | 7.15 | 3.60 | 4.21 |
| 1995 | 5.51 | 7.59 | 8.20 | 5.95 | 7.87 | 8.83 | 5.21 | 5.83 |
| 1996 | 5.02 | 7.37 | 8.05 | 5.75 | 7.80 | 8.27 | 5.02 | 5.30 |
| 1997 | 5.07 | 7.26 | 7.86 | 5.55 | 7.71 | 8.44 | 5.00 | 5.46 |
| 1998 | 4.81 | 6.53 | 7.22 | 5.12 | 7.07 | 8.35 | 4.92 | 5.35 |
| 1999 | 4.66 | 7.05 | 7.88 | 5.43 | 7.04 | 8.00 | 4.62 | 4.97 |
| 2000 | 5.85 | 7.62 | 8.37 | 5.77 | 7.52 | 9.23 | 5.73 | 6.24 |
| 2001 | 3.45 | 7.08 | 7.95 | 5.19 | 7.00 | 6.91 | 3.40 | 3.88 |
| 2002 | 1.62 | 6.49 | 7.80 | 5.05 | 6.43 | 4.67 | 1.17 | 1.67 |
| Highest value | 14.03 | 14.17 | 16.11 | 11.57 | 15.14 | 18.87 | 13.42 | 16.38 |
| Lowest value | 0.01 | 2.53 | 3.05 | 1.64 | 5.81 | 1.50 | 1.00 | 1.57 |
have been traded since the mid-nineteenth century. More recent years have seen commodities markets expand to include trading in foreign currencies, U.S. and foreign government securities, and U.S. and foreign stock indexes.
Since contracts are made before the goods are actually available, commodities are by their very nature speculative. Buyers purchase commodities because they think that their value may increase over time, while the sellers think their value may decrease. For example, the seller of a grain futures contract may believe that there will be a surplus of grain that will drive down prices, while the buyer thinks that a shortage of grain will drive prices up. It is the speculative nature of commodities that makes them interesting to investors. Even if they have no need for the goods that the commodities contracts represent, speculative investors can make a profit by buying the commodities contracts at low prices and then selling them to others when prices rise. Commodities respond differently from stocks and bonds to market forces such as inflation; therefore, they can be a valuable part of a diversified portfolio. However, they are riskier and more difficult to understand.
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