By: Julio Perez, Fall 2017 IAC Graduate Research Assistant
Stocks and bonds are words pretty much everyone has heard, but many people probably don’t know what they exactly mean (or at least I hope I am not the only one). Last week, I explained what a security was and used myself buying stocks and bonds as an example.
“Stock” represents “ownership” in a company (in the business, they call this “equity”). Last week, I described myself as a businessman after buying stock, and if I buy enough stock, I would practically become as much of a businessperson as the one running the company.
Before you can buy stock from a company, the company must be “public,” which I will translate later on in the series. You can also invest in private companies, but that will also be explained later.
Then, the company has to “issue stock,” that is, offer to the outside world a number of shares in the company. This makes sense; you can’t go and buy out companies against their will just because you have money, and this way the actual company founders and owners can keep ownership over their company and dictating what percentage you own. The company may also give you, as a stockholder, the right to vote in certain decisions, such as who their directors should be and other important company decisions.
Using the example of last week, I like fruit leather so much and know so much of the ins and outs of the product that I think I know which direction the company should take. However, I don’t have enough money (capital, as is more appropriately labeled in the business) so I have to pool my funds with other like-minded investors to own a part of the company. Owning this stock lets me share the risks and losses if the company stumbles in exchange for also sharing the profits. Moreover, I can assist in the decision-making process in order to improve my odds of making a profit and mitigate the risks of the business. And who knows, if I do so well and improve the company’s position enough, I may one day buy enough stock to literally run the company.
Then there are bonds. Investor.gov defines a “bond, or debt security, as being similar to an IOU.” You give an entity your money, and they give you a piece of paper promising to pay you back your amount plus interest. I say “entity” because you can buy bonds from companies, banks, government entities, and pretty much anyone who can use a loan (i.e. everyone). When an entity issues a bond instead of a stock, it is mainly because they need your money but don’t want you to own them and because they (and you) feel confident that they can pay back what they owe you by the promised date. After all, if a bank or government is unable to pay you back when they promised, you probably have bigger concerns than getting your loan back.
The drawback to this is that the interest rate tends to be lower on bonds (the safer the investment, the lower the profit margin), and you usually are not allowed to go knocking at the bank’s door waving your IOU and demanding your money back early without harsh penalties on your principal (more on CDs and maturation later). Interest rates also tend to be set at the date of the bond issued, so if you were promised 4% and interest rates jump up to 16% (again, you have bigger concerns), you are only getting the 4% promised to you, barring exceptions such as compounding interest and variable rates, to be discussed later.
In conclusion, the translation to the initial statement would approximately be: “Should I try to make a big profit by owning a piece of my favorite company, hopefully not losing everything in the process, or should I be a lender to the bank and get a small, but safe, profit later on?”
Huh, the first phrase rolls off the tongue much easier.