A stock is a share of ownership in a company, representing a claim on the company's assets and earnings. The importance of being a shareholder is that the investor has a claim on assets and is entitled to a portion of the company's profits, which may be paid out in the form of dividends (Stock basics, 2011).
There are positive and negative aspects to stock ownership. One such positive is that the shareholder is protected by limited liability, that is, he or she is not personally liable if the company is not able to pay its debts. Owning stock means that, no matter what, the maximum value an investor can lose is the value of the investment. Another advantage of owning common stock is that shares are highly liquid for the most part, with many stocks traded daily (Stock basics, 2011).
One of the risks of becoming an owner is that the investor assumes the risk of the company not being successful; the shareholder is not guaranteed a return. Also, if the company goes bankrupt and liquidates, the investor aka shareholder does not get any money until the banks and bondholders have been paid out. Shareholders may earn a lot if a company is successful, but they also stand to lose their entire investment if the company is not successful (Stock basics, 2011).
There are no guarantees when it comes to owning individual stocks, or to dividend payouts either. Even for firms that have traditionally paid dividends, there is no obligation to continue. Without dividends, the only way an investor can make money on a stock is through its appreciation in the open market (Stock basics, 2011).
Risk is not all negative for an investor. Taking on greater risk demands a greater return on one's investment. For this reason, stocks have historically outperformed other investments such as bonds. Over the long-term, investment in stocks has historically had an average annual return of approximately 10-12%, outpacing inflation (Stock basics, 2011). Investors with the appropriate time horizon and risk profile find stocks a good investment.
When businesses need money to help them fund operations, move into new markets, innovate or grow in general, their requirements may exceed the amount a bank can provide. So a useful way for them to raise the necessary funds is to issue bonds to whoever wants to buy them. When investors buy bonds, they are lending money to the organization that issues them. The company, in return, promises to pay interest payments to the investor for the length of the loan (McGrath, 2011).
The amount and frequency of payments to the investor depends on the terms of the bond. Typically the interest rate is higher with long-term bonds, and interest payments may be made monthly, quarterly, semiannually or annually. Once the bond reaches its maturity date, the issuer repays the principle, or original loan amount (McGrath, 2011).
Like stocks, bonds can be traded. But unlike stocks, bonds do not represent a partial ownership interest, therefore bonds are less risky and volatile. Also, unlike stocks which are equity, bonds are debt; the bondholder does not share in the profits if a company does well. The bondholder is only entitled to the principal plus interest (Bond basics, 2011).
Bonds may be issued not only by businesses, but also by governments and municipalities. Bonds from stable governments, like the United States, are considered very safe investments. In some cases, the investor may not have to pay federal, state or local income taxes on the interest that bonds earn (McGrath, 2011).
Whereas corporate bonds issued by businesses are a higher risk than government bonds, they also can earn a lot more money. Organizations such as Moody's Investor Service and Standard and Poor's research and analyze bond issuers to determine bond ratings for an investor to use to measure risk. Typically rating scales are spelled out in letter grades, with AAA designating a safe, low-risk bond and a D. rating designating a high-risk bond. Safer bonds are usually low-yield bonds (McGrath, 2011).
It is generally accepted that stocks return more than bonds, particularly over time periods of 10 years or more. However bonds may be more appropriate for an investor who cannot tolerate the short-term volatility of the stock market. For an investor who cannot afford to lose his/her principal as income or for investors with shorter time horizons, bonds may be the better investment (Bond basics, 2011).
A mutual fund is a company that pools investors' money to invest in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the mutual fund holdings. Investors make money from a mutual fund in one of the following ways:
Income is earned from interest on bonds or from dividends on stocks. A fund pays out nearly all the income it receives over the year to fund owners in the form of a distribution.
If the fund sells securities that have increased in price, the fund has a capital gain; most funds pass on these gains to investors in a distribution.
If fund holdings increases in price but are not sold by the fund manager, the fund's shares increase in price. The investor can then sell mutual fund shares for a profit.
Funds usually offer the choice to either receive a check for distributions or to reinvest the earnings and get more shares (Mutual funds, 2011).
There are several advantages of mutual funds. The first is having a professional manager. Investors also purchase mutual funds because they do not have the time or expertise to manage their own portfolios. A mutual fund offers a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments (Mutual funds, 2011).
Diversification is another benefit of owning shares in a mutual fund. By owning shares rather than individual stocks or bonds, risk is spread out. By investing in a large number of assets, a loss in any particular investment is minimized by gains in others. Other advantages include economies of scale, simplicity and liquidity. A mutual fund is a good choice for an investor who wants to diversify risk and enjoy the convenience of a professionally managed fund, minimizing the investor's need to spend time and effort managing the fund (Mutual funds, 2011).
An option is a type of security, just like a stock or bond. It is a contract that provides the investor the right -- but not the obligation -- to buy or sell an underlying asset at a specific price before the option expires. There are two types of options, calls and puts. A call gives the holder the right to buy an asset at a specified price within a given period of time. Buyers of calls hope that the stock increases substantially before the option expires. Buyers of puts hope that the stock price falls before the option expires (Options basics, 2011).
Because it is a binding contract, options come with strictly defined terms and properties. Also, because an option is merely a contract dealing with an underlying asset, options are called derivatives, because the option derives its value from something else. The underlying asset is most often a stock or an index (Options basics, 2011).
An option does not obligate the investor to exercise it; one can always let the expiration date pass, as which point the option becomes worthless. If this occurs, the investor loses 100% of his or her investment, the money used to pay for the option (Options basics, 2011).
Investors choose options for one of two main reasons, to hedge or to speculate. Hedging is similar to buying an insurance policy; options can be used to insure one's investment against a downturn. Hedging strategies can be particularly useful for large institutions, but the individual investor can benefit as well. For example, if an investor wanted to take advantage of technology stocks and their upside, but also wanted to limit any losses, that investor can use options to restrict their downside, while cost-effectively enjoying the full upside (Options basics, 2011).
Investors use options to speculate or bet on the movement of a security. The versatility of options allows the investor to make money when the market goes up, down or even sideways. Using options in this way is considered to be very risky; one can make or lose large sums of money. To be successful, the investor must correctly predict not just whether a stock will go up or down, but must also be right about how much the price will change, as well as the time frame it will take to happen; also one must factor in commissions. Given that the odds are skewed against the investor, one might wonder why people speculate with options. The answer is that options take advantage of leverage: when one can control 100 shares with one contract, not much of a price movement is required to generate substantial profits (Options basics, 2011).