Running With Scissors
Created | Updated Jun 21, 2005
This week we're going to demystify some of the financial jargon that you hear spouted by the talking heads on news broadcasts and by your obnoxious brother-in-law. The good news is that financial talk can sound a lot more complicated than it actually is. Here is a quick look at various types of investments.
The Fine Print
The articles in this series do not offer specific financial advice. Instead they will present financial tips, with occasional smart-aleck observations and commentary, that may or may not be useful in the reader's particular situation. You should always seek advice from a professional who is familiar with your personal circumstances before acting on any of the information presented in this series.
About Stock
Stock represents ownership in a company. A company will raise money by selling shares that entitle the buyer to various rights of ownership. These rights can include voting on certain matters and receiving dividends, which are portions of the company's profits that are distributed to shareholders.
Shares of stock are traded on various exchanges such as London Stock Exchange or the New York Stock Exchange (NYSE) and NASDAQ in the US. Anyone1 can purchase shares; you simply need to open an account at a licensed brokerage firm in your country. The price of a company's shares will fluctuate depending on the value of the company and how investors feel about it. Ideally there is a close relationship between the actual value of a company and the price of its stock, but this isn't always the case. For one thing, it can be difficult to assess a company's real worth. Its financial state is in constant flux, so the best we can do is look at a 'snapshot' at a particular point in time2. In addition, accounting rules (in the US, at least) do not allow companies to list various intangibles such as patents, brand names or copyrights as 'assets'. And part of a company's value is in its expected earnings over the coming year, something that is determined in part by factors outside a company's control such as the state of the economy. Another reason that the price of a stock can differ from the company's real value is that stock prices are affected by what financial commentators refer to as 'investor sentiment'. If people are feeling pessimistic about the economy and their own prospects, they're less eager to buy stock, and so share prices can fall. If they're feeling optimistic, they'll often bid up the price of stocks to unreasonable levels.
A period of time during which the prices of most stocks are falling is called a 'bear market'. In contrast, a period of generally rising stock prices is called a 'bull market'.
The mantra of every investor is 'buy low, sell high'. This is easier said than done, as you have to act in direct opposition to investor sentiment, and professional money managers often do no better at this than the average investor. The best time to buy stock is during a bear market because shares generally sell at less than their real worth (think of it as a sale on stocks). The worst time to buy is during a bull market when shares are generally overvalued. Naturally this is when everyone, especially your brother-in-law, wants to get in on the act, and everybody likes to talk about how much money they've made on such and such. During such times the smart investor grits his teeth, sits on his hands, and ignores all the hoopla. Eventually some event will cause everyone to come to his senses and share prices will fall. Your brother-in-law, who paid £1,500 for 100 shares of Amalgamated Widgets & Doodads (AWD), will suddenly find himself owning shares that are now worth maybe £1,000, which he will sell in a panic, leaving him £500 poorer but probably no wiser.
About Bonds
A bond is a certificate of debt issued by governments or corporations that guarantees repayment of the amount of the bond (ie, the principle) plus interest by a specified date in the future (called the 'maturity date'). A person who purchases a bond essentially loans money to the entity that issued it.
In the US, bonds are sold in $1,000 increments. Bonds are rated by agencies according to how safe they are (ie, the likelihood that the issuer will default on its payments). Not surprisingly, bonds issued by governments and governmental agencies are considered the safest. Bonds issued by corporations are considered the less safe, and if a corporation is in financial distress, its bonds may be downgraded to 'junk bond' status3. The safer the bond, the lower the interest that it pays. Junk bonds carry the highest interest rates — they have to do this to compensate buyers for the greater risk of default. In addition, the further away a bond's maturity date is, the higher the interest rate it pays, because the buyer's money is tied up longer.
During periods of rising interest rates, the value of a bond will fall; if interest rates fall, a bond's value will rise. Sound confusing? Here's why. Imagine that you own a $1,000 bond that pays 3% interest. If interest rates rise, the issuer will sell bonds that pay 3.25% — this makes your bond less attractive, so if you want to sell it, you'll have to sell it for maybe $900. Similarly, if interest rates fall, new bonds will carry an interest rate of maybe 2.75% — this makes your bond more valuable, so if you sell it, you may receive $1,100 for it. The sooner a bond matures, the less its price will fluctuate due to changes in interest rates. This means that if you expect interest rates to rise, you're better off buying a bond with a lower interest rate that matures in two or three years than with a longer-term bond that pays a higher rate.
Bonds are widely considered to be safer investments than stocks. The price of a bond fluctuates much less than that of a stock, and the issuer of investment grade bonds rarely defaults, although this can happen. However, this also means that the price of a stock can rise much more than that of bonds, earning the investor a much greater return. In addition, should a corporation go bankrupt, bond holders are creditors and are entitled to repayment of all or a portion of their bonds; stock holders are owners of the corporation and entitled to whatever is left over after the creditors have been paid, which is frequently nothing. Historically in the US, stock is the only investment class that has outpaced inflation. This may not sound particularly important, but it is. We'll look at inflation in next week's article.
About Money Markets, Certificates of Deposit, and the Like
The safest investment is cash and 'cash equivalents' such as money market accounts. As you may have guessed, this safety comes at a price, as these kinds of accounts pay the least amount of interest, and some may pay no interest at all.
In the UK, savings held in authorised banks and building societies are protected under the financial services compensation scheme (FSCS). FSCS protects 100% of the first £2,000 and 90% of the next £33,000 if a firm is unable to pay claims against it. In the US, deposits up to $100,000 held in banks or other insured institutions are guaranteed by the Federal Deposit Insurance Corporation (FDIC).
Cash is generally considered pretty boring, but it's the place to keep money that you may need to access on short notice. This would include savings to tide you over in the event of job loss or other financial emergency and perhaps your savings toward a down payment on a house.
Some More Exotic Investments
There is a class of investments known as 'derivatives' because they derive their value from other investments. Clear as mud, huh? Let's look at an example that you may have heard of: stock options. A stock option is an investment that gives you the right to purchase a certain number of shares of stock for a particular price. Such options are often used as a form of compensation for CEOs and other corporate bigwigs, as they give these folks the right to purchase large blocks of shares of their company's stock for a price that's generally much lower than the current trading price on the stock market. Average investors can also buy purchase stock options; generally all you need is a brokerage account that offers option trading.
The value of an option fluctuates along with (ie, is derived from) the price of the underlying stock. For example, you may buy an option that allows you to purchase 100 shares of Amalgamated Widgets & Doodads for £40 per share. If AWD is currently trading at £38 per share, that option isn't worth much, but if the price of AWD rises to £41, then your option becomes valuable. If AWD continues to rise, your option becomes increasingly valuable. If you can purchase the 100 shares of AWD, paying £3,800, and immediately sell them for, say, £4,200, you've just made £400 (less various trading costs).
There are a whole boatload of derivatives out there. In general, they can be tricky to understand, but someone who knows what he's about can make a good deal of money with them. He can also lose a good deal of money if things don't go as planned, which is why derivatives are not for the inexperienced investor. Derivatives are also used by professional money managers such as those who manage pension funds to help stabilise the value of these funds. So they have their place, but most of us get along just fine without them. When your brother-in-law starts spouting off about his options, just ignore him because chances are he'll soon get a painful lesson.
What's a Mutual Fund?
A mutual fund is an investment that pools the money of many shareholders and invests this money in stocks, bonds, cash, derivatives, or some combination of these. These funds come in all flavours and sizes. There are stock funds, bond funds, balanced or income funds that own some mixture of stocks and bonds, funds that invest only in the US or in other countries, funds that invest only in one industry, and the like. There are even funds comprised of other mutual funds. As with stocks and bonds, a mutual fund's shares fluctuate in price based on the values of the securities held by the fund.
In the US mutual funds have made stock ownership and investing in general more accessible to the average person. In fact many get their first taste of investing through mutual funds. Because of this, and because of the variety of funds available, they will be the subject of their own article in the future.
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So those are the basics. Stock represents ownership in a company. Bonds mean you've loaned someone money which they will repay with interest. Cash is a safe haven for money you may need to put your hands on quickly. Most financial advisors suggest that a person invest various portions of his money in all three areas, with the percentages varying according to that person's individual circumstances. In general, the more volatile shares of stock are appropriate for long-term investing such as retirement savings, since you have plenty of time to ride out the inevitable bear markets. Bonds, with prices that don't vary as much, can help keep the value of your retirement accounts more stable, and they are also appropriate for non-retirement savings that you won't need to touch within the next few years. However, do keep your eyes on what interest rates are doing.
And the next time your obnoxious brother-in-law starts pontificating about his investment strategy, just tell him that in your opinion current economic factors don't support market valuations and the smart money is in cash. Then enjoy watching him grope for a response.
References and More Information
Sound Money, a weekly radio program in the US covering financial topics, offers this list of Web sites that provide more information on investing.
