Chapter 31: Investing

Bonds

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Setting Investment Goals

• Investing is using money to participate in an enterprise that offers the possibility of profit.
• It usually involves careful planning and goal setting.
• There are two goals that everyone should set before starting to invest.
  • First, you should limit your credit card charges and reduce or eliminate credit card debt.
  • Second, start an emergency fund and add to it as your income increases.
  • It is recommended that people save enough money to cover at least six months of expenses.
• Once you achieve these two goals, start looking at the different investment options that are available to you.
• It is a good idea to meet with a financial adviser annually to review your portfolio and goals.
• Investment options include securities.
  • A security is a tradable document that shows evidence of debt or ownership.
  • Securities include bonds, shares of stock and mutual funds, and stock options.
• The return on an investment is the amount of money the investment earns, or the yield.

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Investing in Bonds

• When corporations or governments need to borrow large amounts of money, they often issue bonds.
  • A bond is a certificate issued by a government or company in which it promises to pay back borrowed money at a fixed rate of interest on a specified date (the maturity date)
• Investing in bonds is similar to putting money into a savings account.
• The rate of interest on a bond is referred to as the coupon rate.
  • This rate is also referred to as the yield.
• Interest is usually paid once or twice a year.
• Bonds may be sold at a discount, or below their face value.
  • Face value is the value of a security that is set by the company or government that is issuing it.
• The difference between the amount you pay for the bond and its face value is the bond discount.
• There are two types of bonds you can buy: government bonds and corporate bonds.

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Government and Corporate Bonds and Securities

• Federal, state, and local governments issue bonds to help raise the money to fund their regular activities.
• The interest paid on a bond can be higher than the interest paid on a savings account.
• The U.S. Treasury Department issues four basic types of securities: Treasury bills (or T-bills), notes, bonds, and savings bonds.
• Investors can buy these securities through banks or brokerages, which charge a commission
• Treasury bills are sold in units of $1,000.
  • They may reach maturity in four, 13, or 26 weeks.
  • T-bills are discounted securities, which means the purchase price that investors pay is less than the face value of the T-bill.
  • On the maturity date, the investor receives the full face value of the T-bill.
• Treasury notes are issued in $1,000 units, with a maturity of between two and 10 years.
• Treasury bonds are issued in $1,000 units, with a maturity of 30 years.
• Generally, the interest rates on notes and bonds are higher than on T-bills because of the increased risk of the rates rising or falling during the length of time until the note or bond matures.
• Savings bonds are registered bonds that are sold in denominations of $50 to $10,000.
  • They allow people to earn interest on the savings they entrust to the government in exchange for the bond.
• A Series EE savings certificate costs half the amount of its face value to buy
  • After a certain number of years, it becomes worth its full face value.
• Another type of savings bond is the Series I bond.
  • Investors pay the face value for Series I bonds.
  • The interest rate on this bond fluctuates with the rate of inflation over time
• EE bonds and I bonds are attractive to people who want safe, guaranteed long-term investments.
• Besides the securities issued by the Treasury Department, bonds are issued by other federal agencies as well.
  • However, they offer a slightly higher interest rate than treasury securities.
  • Their maturities range from one to 30 years, with an average life of about 12 years.
  • Generally, their minimum denomination is $25,000.
• Local and state governments issue municipal bonds.
  • Municipal bonds are sold to finance city, town, or regional projects such as schools, highways, and airports.
  • You can buy them from a broker or directly from the government that issued them.
• Bonds issued by corporations are called corporate bonds.
  • Corporate bonds can be bought and sold through brokerage firms.
  • They are usually used to finance construction and equipment.
• The value of a corporate bond fluctuates according to the overall interest rates in the economy.

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Advantages and Disadvantages of Buying Bonds

• Bonds have many of the same advantages and disadvantages as savings accounts.
• One advantage is that most bonds are secure, especially those from government and large, established businesses.
• In particular, bonds and other securities issued by the U.S. government enjoy the full faith and credit of the federal government.
• Bonds also pay interest.
• Although they are liquid, one disadvantage of bonds is that an investor can lose money if a bond is sold or redeemed before it matures.
• Most bonds are written for a minimum of $1,000, which may make them out of reach for some investors.
• Like savings accounts, bonds may not keep up with inflation

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Stocks

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Investing in Stocks

• A stock is a share of ownership in a corporation.
• When you buy stock, you receive a stock certificate that indicates ownership in a corporation.
• Stock prices may change throughout the day, every business day.
  • There is no promise that a stockholder will get his or her money back or that he or she will receive income from owning stock.
  • Therefore, stocks are generally more risky than bonds.
• Companies that sell stock must follow rules set up by the Securities and Exchange Commission, or SEC.
  • The SEC is a U.S. government agency that supervises the exchange of securities to protect investors from wrongdoing.
• The amount of money the stock earns depends on its type of return and rate of return.
• There are two ways that you can receive a return on stocks.
  • One is through the payment of dividends, which is a share of profits given to stockholders.
  • Dividends are usually paid quarterly in cash or in more shares of stock.
  • Many stockholders receive a return on stock when they sell it.
  • Selling stock for more than you paid for it results in a capital gain.
    • A capital gain is a profit made from the sale of a financial asset such as stock or a bond.
    • A capital loss is an amount lost when an asset is sold for less than its cost.
• The rate of return on stocks is always expressed as a percentage of the original investment and figured on an annual basis.
• When a company sells stock, it usually offers two different types.
  • Common stock is stock that provides the most basic form of corporate ownership.
  • Preferred stock is stock that gives the owner the advantage of receiving cash dividends before common stockholders receive any.
• A dividend does not have to be paid each year.
• Stocks carry different levels of risk.
  • Blue-chip stocks are stocks in large, well-established companies that have a good track record of success and profitability.
  • Speculative stocks are stocks in new firms without an established track record.
• A stockbroker is a person who buys and sells stocks, bonds, and other securities for clients.
  • Stockbrokers act as a link between buyers and sellers.
  • As a fee for their services, stockbrokers charge a commission, which is either a percentage of the value of the stock or a set amount for each transaction.
• Many people lower their investment fees by buying and selling securities using the Internet.
• Most stocks are bought and sold through a trading market known as a stock exchange.
  • A stock exchange is an organized market for buying and selling financial securities.
  • Some of the best-known exchanges are the New York Stock Exchange (NYSE®) and the American Stock Exchange (Amex®).
• Over-the-counter securities are not listed or sold through stock exchanges.
  • They are traded directly between buyers and sellers in person or via computer.
  • The NASDAQ is an electronic stock market system that quotes over-the-counter securities.
• Mutual funds lessen the risk of investing in the stock market.
  • A mutual fund is a fund created by an investment firm that raises money from many shareholders and invests it in a variety of stocks or other investments.
• Most people who are investing for retirement will own individual stocks or bonds for a number of years.
• Long holding periods are an excellent way to build wealth while minimizing risk.

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Advantages and Disadvantages of Stocks

• A general principle when investing is that the greater the risk, the greater the possibility of a larger return.
• A major disadvantage of stocks is that you have more risk of losing your investment when putting money into them rather than a savings account or bonds.
• However, a big advantage of stocks is that long- term comparisons of returns on stocks and returns from savings accounts or bonds show stocks do better over time.
• If a company declares bankruptcy, its stockholders may receive little or none of their investment back.
• Liquidity refers to how easily an investment can be turned into cash.
  • Most stocks can quickly be turned into cash by selling them.

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