There are 3 main broad classes of common investments, they are: stocks, index/mutual funds and bonds. Each have their various associate risk and potential reward. Generally speaking, stocks are the riskiest although hold the greatest potential for reward, while bonds are the most stable, but tend to provide lower yields. Let's explain the common investments:
Common stocks
A common stock (or share) is a piece of a company that you are purchasing off the market. The market consists of a pool of investors (some individual investors, like yourself) that are agreeing to purchase and sell shares at a given price. In the general case, when you place an order to purchase a stock you are buying it from another investor who has agreed to sell his stock at the price you have agreed to pay. When you own a stock of a company you own a very small portion of that company. For example, if you buy a share of Apple (ticker symbol AAPL), which currently has a total of 5.54 billion shares in the market, you would own 1/5,540,000,000 of Apple. So yes a very small piece, but a piece never-the-less!
Shares rise and drop in value over time due to changes in market dynamics that influence the desire for the share. One basic example of this, if Apple releases a brand new product that is very popular and proving to be very profitable, more people will be interested in owning the stock and thus the price would rise as there is a finite quantity of it. This is a very simple depiction of one reason why a stock could rise. On the flip side, if you own a solar panel company such as Fist Solar, and news comes out that the federal government will no longer subsidize the solar industry, the stock will likely drop due to decrease in forecasting sales. The price of a stock fluctuates with the demand/desire for it.
One fantastic place to obtain information about companies is yahoo finance. It is definitely a better source for stocks traded the U.S. market (NYSE) than for Canadian stocks (listed under the TSX). In the search box you will need to enter either the company name of the ticker (stock) symbol. Every publicly traded company has an associate ticker symbol. For stocks on the Toronto Stock Exchange (TSX - the Canadian stock market). That symbol will be followed by .TO, for example TD bank is traded on both exchanges and has symbol TD.TO on the TSX and simply TD on the NYSE. (Overview of Yahoo finance)
There are two ways you make money from owning a common stock are either by price rising or through dividends. We have discussed the price fluctuation briefly above. In terms of dividends, certain companies share some of their profits with shareholders. The payments of these shared profits are called dividends. Dividends can be paid out monthly, quarterly or yearly. If we go back to the Apple example, they currently have a dividend yield of 2.05%, or $2.08/stock (currently trading at $99.99/stock). Let's assume this stock pays quarterly and that you owned 100 shares of Apple (currently worth $9,999). Every quarter you would receive ($2.08/4)*100 = $52 from Apple, or a total of around $204 on the year.
We'll leave common stocks at that for now. We will discuss some of the key statistics that you encounter in Yahoo finance to help assess a company in an upcoming article. (article link)
Index/Mutual Funds
A mutual fund is a professionally managed portfolio that is funded by a pool of investors. For example, it can consist of a 5 million dollar portfolio run by a major bank that includes $10,000 investments by 500 individual investors like yourself. The managers of the portfolio than purchase stocks or other investments on behalf of the investors to try grow the portfolio to beat the stock market. In exchange for their expertise, the mutual fund charges an MER (management expense ratio), which is a percentage of your total investment. MERs will be in the range of a couple percentages (average around 2.5%). This represents a yearly fee of (2.5/100) *$10,000=$250 for each of our 500 investors listed above. The MER is a flat fee that is charged whether or not the portfolio does well that given year.
Index funds are similar to mutual funds except they are aimed at following, or tracking markets as apposed to beating them. For example, a TSX index may consist of 100 of the biggest TSX companies, thus if the TSX rises 5% in a given year, you can expect your index to have a similar return. The major benefit of buying index funds are the low costs associated. Some of the cheapest index funds currently available to Canadians can have an MER around 0.33%. That means this specific investment would cost you around 7 times less per year to own than an average mutual fund. Index funds can afford to be much cheaper as they are managed in a more passive method (less analysis, marketing and trading).
We will expand greatly on index funds within this blog, keep posted!
Bonds
If a company or government wishes to raise money for various projects or activities, one way of doing so is to ask the public (through the market place) for a loan. They borrow the funds for a period of time and, in return provide interest on the loan. For example, if Bill's Burger company wishes to open 5 new stores in New York but is currently short on cash and each store costs $500,000 to open, they can issue a bond to raise the $2,500,000. The bond would then come with an associated coupon (interest rate), a maturity date (when the loaned funds are returned) and a credit rating for the bond. In our burger example, let us say the face value per bond is $1,000 (must buy in $1,000 units), we would have the following situations as issuance:
Principal: $2,500,000
Interest rate (annual coupon): 5%
Maturity date: January 2026 (10 years)
Credit rating: A- (fairly high quality, this burger company has a strong credit rating).
There are thus a total of $2,500,000/$1,000 units=2,500 units available.
In the simplest case, say you buy 10 units of this bond (a total loan of $10,000 to Bill's Burger) would you receive $500/year in cash flow for 10 years, after which Bill's Burger would return your initial $10,000 and you would thus have made $500/year*10year=$5,000 on your investment.
A bond's market value can rise or fall during the 10-year period in response to interest rates available in the market place. If interest rates drop to 3.5% and your bond continue to pay 5%, you bond is now of higher value. To correct for this, the price per unit would eventually increase to $1,000*(5/3.5)=$1428.5. In this way, bond prices rise if interest rates drop and vice versa.
- Yinvestors.
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