You may have heard family
members or friends say I own stock, I own bonds, mutual funds or ETFs. If
you are an individual with little to no investing experience or knowledge you
maybe one wonder what the hell are these people talking about. No worries
this episode is designed to help you understand the basics of these securities.
I will go through the more common types of securities and address the more
complicated ones in a later episode. No need to scare you now, I like to
build up the suspense and scare the shit of out you later.
Now that you went to a
full service broker or online discount broker and opened an account now it is
time to invest your hard earn cash and purchase securities. The first
such securities and perhaps the most well-known is stock (also known as
equity). Stock
provides an investor ownership and voting rights at shareholder meetings in a
corporation. Stock also entitles the investor a claim on the
corporation's assets and earnings. Companies’ issues stock to the public
in an effort to raise money. These
events are called Initial Public Offerings or Secondary Public Offerings. I will address those in later episodes. Also investors buy and sell stock in the
market. There are two main forms of stock, common and
preferred.
Common Stock typically provides a shareholder (investor) voting rights and receive
dividends. Common stockholders are at
the bottom of any claim on the company’s assets in a bankruptcy and liquidation
(click the stock link for details). Preferred Stock is similar to common stock except usually preferred stock does
not have voting rights. Generally
preferred stock pays a dividend which must be paid before common stock
dividend. You may have guessed preferred
stock has a higher claim on a company’s assets than common stock during a
bankruptcy and liquidation. Another type of stock which is less common is
called Convertible Preferred Stock.
Convertible preferred
stock contains an option to buy a fixed number of common stock.
Another type of
securities which companies’ issue and investors trade in the market is
bonds. Bonds (also known as fixed income) are a form of loan
or IOU to the creditor or simply are debt instruments (securities) which a
company borrows money from investors.
These debts securities which the issuer promises the holder (bondholder)
to pay in full at a specific date (maturity date) all the proceeds (principal)
that was borrowed from the bondholder.
Depending on the terms, the issuer usually provides a fixed rate of
interest (coupon) at a predetermined frequency, typically semiannual which is
known as a coupon payment. The creditor
earns a yield
on the debt investment. Assuming the
creditor purchase a bond at par,
the yield the investor earns is equal to the coupon, also assuming the creditor
holds the bond to maturity. Bonds have a higher claim on a company’s asset than
preferred and common stockholders in a bankruptcy and liquidation. Depending on the issuer some bonds maybe tax
exempt and have different levels of risk.
There are many forms of
bonds issued by many entities such as governments and corporations but I will
stick with the most common types. The U.S. Federal Government issued bonds to fund programs, departments, courts and its daily
operational needs. These government bonds
come in different forms and maturities, but the most common forms are Treasuries and Treasury Inflation Protected Securities (TIPS). Treasuries
and TIPS are backed by the full faith and credit of the U.S. Government. Treasuries
and TIPS instruments can be issued as T-Bills which are short term fixed income
typically less than 1 year in maturity (90 day T-Bills are the most common) and
Treasury Bonds which have maturities of greater than 1 year, the most common at
10 and 30 year maturities.
State and local
governments such as cities also issue bonds which are typically called Municipal Bonds. These bonds are typically
called General Obligation Bonds (GO) and Revenue Bonds. GO bonds are very similar to Treasuries which
are back by the full faith and credit of issuer which are states and cities in
the U.S. Revenue Bonds are back by revenue generated from projects which are typically
stadiums, toll bridges and mass transit systems.
Foreign governments also
issued bonds some are similar to U.S. Treasuries and U.S. TIPS. Foreign government bonds also known as
sovereign debt. These types of bonds are so broad with different structures,
taxations and rules I will not attempt to address them. In the U.S. market place foreign government
bonds are associated with terms like global fixed income and emerging market fixed income. Don’t
worry about these terms they are just Wall Street marketing to classify bonds from
certain regions and risks. I will
address them later episode of how Wall Street classifies investments.
Besides governments,
private corporations issue bonds they are known as corporate bonds. These bonds are similar to their governmental
cousins, they are debt instruments backed by the full faith and credit and
revenue streams of a corporation. Just
like their governmental cousins they contain maturities and coupon rates. Corporate bonds have the highest level of
claim on a company’s assets during a bankruptcy or liquidation. However unlike their governmental cousins all
interest earned are subject to taxes. Also
corporation will issue convertible bonds which convert the bonds into a fixed
number of common or preferred stock. Wall
Street markets corporate bonds under several names such as investment grade and
high yield (also known as Junk Bonds). Once
again don’t worry I will address Wall Street Marketing on a later episode.
Another common form or
securities are Mutual
Funds. Mutual Funds are pools of
money collected from many investors to purchase securities by professionals
called portfolio managers or money managers who charge a fee for their services.
These investors are given shares of the
mutual fund but do not have direct claim of the securities held within the
mutual fund but only on the assets of the mutual fund. There are two types of mutual funds called
open end and closed end. Closed
end funds are publically traded investment companies that have very little
in common with their open end cousins.
The fund is structured similar to stock with a fixed number of shares
and trades on a stock exchange. Open
end mutual funds don’t trade on exchanges and can issue an unlimited amount
of shares. Open end mutual funds are the
most common type of portfolio investment.
Typically they are found in one’s 401k plan or IRA. Typically investors who own mutual funds have
very little investment experience or have very little time to manage their but
prefer to have a professional actively managed their assets. These active mutual funds are measured against
a benchmark to determine success of the portfolio manager. I will address benchmarks and how to measure
the success of active managers in a later episode. However there are non-active mutual funds
called index funds. These funds
replicate an index such as S&P 500. Since these funds are not actively managed
their fees are much lower than their actively managed cousins.
Another form of
portfolio investment is called Exchange Traded Fund (ETF)
and Exchange
Traded Note (ETN). ETFs are investments
funds like closed end fund. ETFs trade
on a exchange like stock and usually hold assets such as stocks, bonds and
commodities. Similar to index mutual funds
ETFs are based on a specific index and just like index funds the management
fees are dirt cheap. In some cases the
cheaper relative to most mutual funds. ETN
are similar to ETF their assets are based by an underlying index. Unlike ETFs, ETN are unsecured debt
instruments issued by banks. Unsecured debt just means the ETN is not backed by
any collateral or asset besides the underlying investments. If the bank goes bankrupted it is possible
the ETN could lose value.
Hedge Funds are very similar
to mutual funds however they can invest in a broader range of assets that goes
beyond the Investment
Company Act of 1940. Hedge Funds employ
many investment strategies that most mutual funds cannot use due regulations
and their investment mandate. Typically
hedge funds carry a much higher management fee relative to mutual funds and may
require higher minimum investments. Hedge
Funds can be complicated investment vehicles which go beyond the scope of this
episode. You can talk to you investment
professional to learn more about hedge funds.
There are other types of
investment securities such as private equity funds, real estate investment
trusts (REIT), Master Limited Partnerships (MLP), variable annuities, fixed
annuities, life insurance, options, futures contracts and currencies. If you want to learn more about any of the securities
I mention and their implications with taxes and risk please discuss them with an
investment professional.
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