Bonds, and Cash: The Basics
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
What they are
A share of stock represents a percentage of ownership in a corporation.
In other words, if a company is divided into a million shares
and you buy one share, you would own one millionth of that company.
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.
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.
You feel Happy Donuts Company (HDC) is poised for tremendous growth.
They make delicious donuts and the company seems to have a strong
and stable management team. HDC stock is currently $5 per share.
You buy one hundred shares, costing you $500.
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.
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.
What they are
A bond is a loan to a company or government, with you as the bondholder
being the lender. Organizations issue bonds when they want to
raise funds. In exchange for the loan, interest (called the coupon)
is promised. There are investment grade bonds (low risk, low coupon)
and junk bonds (high risk, high coupon). Maturity time frames
(the date you get your initial investment back) vary from one
to thirty years, depending on the issuer.
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.
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 A: The city of San Francisco issues bonds to raise funds
to paint the Golden Gate Bridge blue. You think this is a fine
idea, so purchase a $5000 bond with a maturity date of three years
and a four percent coupon. Every six months you receive $100.
Three years go by, the bridge is blue, and you redeem your $5000
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.
What it is
In a portfolio, cash (called "cash equivalents") is
comprised of several types of low interest, low risk investment
vehicles. These include Treasury Bills, certificates of deposits
(CDs), money market accounts, and money market funds. Though considered
safe, the low return means interest may not keep up with inflation.
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 A: Not wanting to tie up your money for longer than a
year, but seeking an investment that will be exempt from state
and local taxes, you buy Treasury Bills. They are short-term (one
year or less) bonds that are guaranteed by the U.S. government.
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.
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.
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.