People keep their savings in banks and savings and loan associations because they want a safe rate of interest. If people are willing to take a chance on earning a higher rate of return, however, they can invest their savings in other ways.
Stocks and bonds offer investors greater returns, but, at least for stocks, with more risk. As you read this section, you’ll learn hat stocks and bonds are, and why they carry a risk.
Stocks and Bonds
Stockholders are owners of a corporation, and bondholders are creditors of a corporation.
Economics & You Would you rather save what you earn, or risk it in the hopes of earning more? Read on to learn about investing in different types of stocks and bonds.
Corporations are formed by selling shares of stock (also called securities). By issuing stock for sale, a company obtains funds for use in expanding its business. Shares of stock entitle the buyer to a certain part of the future profits and assets of the corporation selling the stock. The person buying stock, therefore, becomes a part owner of the corporation. As proof of ownership, the corporation issues stock certificates.
Stockholders, or owners of stock, benefit from stock in two ways. One is through dividends, the return a stockholder receives on the amount that he or she invested in the company. The corporation may declare a dividend at any time during a year. Dividends typically are paid only when the company makes a profit. The other way people benefit from stock is by selling it for more than they paid for it. Some people buy stock just to speculate, hoping that the price will increase greatly so they can sell it at a profit.
Capital Gains and Losses
Suppose a person buys stock at $20 a share and sells it for $30. The profit of $10 per share is called a capital gain. Of course, the value of stock may also fall. If a person decides to sell stock at a lower price than he or she paid for it, that person suffers a capital loss. Money may be made or lost on bonds in much the same way.
Corporations hold annual stockholders’ meetings, where all stockholders are invited to come together to discuss issues of interest to the company, including plans for the future. Often, elections are held to determine the membership of the board of directors.
Instead of buying stock, people with funds to invest can buy bonds. A bond is a certificate issued by a company or the government in exchange for borrowed funds. It promises to pay a stated rate of interest over a stated period of time, and then to repay the borrowed amount in full at the end of that time. A bondholder lends for a period of time to a company or government and is paid interest on that amount. At the end of the period, the full amount of the borrowing is repaid. This period of time is called the bond’s maturity.
Unlike buying stock, buying a bond does not make a bondholder part owner of the company or government that issued the bond. The bond becomes part of the debt of the corporation or government, and the bondholder becomes a creditor. Figure 6.3 below lists these and some other differences between stocks and bonds.
Local and state governments also sell tax-exempt bonds. The interest on these types of bonds, unlike bonds issued by companies, is not taxed by the federal government. Interest that you earn on bonds your own city or state issues is also exempt from city and state income taxes. Tax exempt bonds are good investments for wealthier people who would otherwise pay high tax rates on interest earned from investments.
Figure 6.3 Differences Between Stocks and Bonds
Stocks and bonds can both be good investments, but there are key differences between them that investors should be aware of before making any purchasing decisions. Be sure you have studied these differences before investing in either option.
The U.S. government issues savings bonds as one of its ways of borrowing money. They range in face value from $50 up to $10,000. The purchase of a U.S. savings bond is similar to buying a bank’s certificate of deposit. Savings bonds are attractive because they are very safe, and because the interest earned is not taxed until the bond is turned in for cash.
A person buying a savings bond pays half the bond’s face value. You could purchase a $50 bond, then, for only $25. The bond increases in value every 6 months until its full face value is reached. If you choose to redeem a U.S. savings bond before it matures, you are guaranteed a certain rate of interest, which changes depending on rates of interest in the economy.
T-Bills, T-Notes, and T-Bonds
The Treasury Department of the federal government also sells several types of larger investments. Treasury bills mature in a few days to 26 weeks. The minimum amount of investment for Treasury bills is $1,000.
Treasury notes have maturity dates of 2 to 10 years, and Treasury bonds mature in 30 years. Notes and bonds are sold in minimums of $1,000. The interest on all three of these government securities is exempt from state and local income taxes, but not from federal income tax.
Stock and Bond Markets
Ownership of stocks and bonds can be transferred on centralized exchanges or in decentralized markets.
Economics & You If you had $500 to invest in stocks or bonds, how would you decide what to do? Read on to learn about different investment markets.
Stocks are bought and sold through brokers or on the Internet. A broker is a person who acts as a go-between for buyers and sellers. If an investor is interested in buying or trading corporate shares, he or she can contact a brokerage firm, which will perform the service for a fee.
Thousands of full-service brokerage firms throughout the country buy and sell stocks daily for ordinary investors. The fees they charge to perform the trades—up to $500—depend on the dollar amounts invested or traded. Today, however, if an investor has an account with an Internet brokerage firm, the cost for the same trade may be as low as $7.
There are well over 100 online brokerage firms, with more springing up on the Web every day. It is estimated that 20 million American investors use the Internet to make trades every year.
Brokerage houses communicate with the busy floors of the stock exchanges. The largest stock exchange, or stock market, is the New York Stock Exchange (NYSE) in New York City. There are also supplemental stock exchanges and regional exchanges—such as the Chicago Exchange—and exchanges in other countries—such as the London and Tokyo stock exchanges. To be listed on these exchanges, a corporation offering stock must prove to the exchange that it is in good financial condition. Most of the companies traded on stock exchanges are among the largest, most profitable corporations in the country.
Buying Stocks or Bonds
If you decide to buy stocks or bonds, you will need to contact a broker. You pay the broker a fee to purchase the stock at one of the stock exchanges.
Stocks can also be sold on the over the counter market, an electronic marketplace for stocks not listed on the organized exchanges. The largest volume of over-the-counter stocks are quoted on the National Association of Securities Dealers Automated Quotations (NASDAQ) national market system, which merged with the American Stock Exchange in 1998.
Unlike organized stock exchanges, over-the-counter stocks are not traded in any specific place. Brokerage firms hold shares of stocks that they buy and sell for investors.
For example, assume that XYZ Corporation is a company that sells computers. If an investor wanted to buy stock in it, he or she would check the NASDAQ listings in the local newspaper or on the Internet. This table of over-the-counter stocks would list XYZ Corporation, the number of shares of stock sold the day before, and the price at which shares were bought and sold that day. The investor would then call a broker or use the Internet to buy a certain number of shares. Usually stocks are sold in amounts of 100 shares, but some brokers will handle smaller amounts.
Trading on the Internet
Today, many people choose to use the Internet to buy and sell stocks and bonds rather than calling a broker on the phone. Many investors who trade this way assume they have a direct connection to the market in which they’re trading, but this is not the case. The orders of Internet traders still go through a broker, just as call-in orders do .
Stock Market Indexes
Almost every weekday, there is news about what happened to the stock market indexes, of which there are many. Such indexes are based on what happened to the stock prices of various listed companies. The most well known is the Dow Jones Industrial Average —often called “The Dow.” This index involves 30 major industrial companies in the United States. There is also the Standard & Poor’s 500 (S&P 500). The S&P 500 index tracks the stock prices of 500 companies.
The New York Exchange Bond Market and the American Exchange Bond Market are the two largest bond exchanges. Bonds, including U.S. government bonds, are sold over-the-counter and on the Internet. There is an enormous variety of individual bonds to choose from. If you decide to invest in bonds, you will probably want to contact a financial adviser to help you find a bond that matches your needs and expectations.
Many people invest in the stock market by placing some of their savings in a mutual fund, an investment company that pools the funds of many individuals to buy stocks, bonds, or other investments. Most mutual funds hold a variety of stocks or bonds. Losses in one area are likely to be made up by gains in another.
Most mutual funds use the S&P 500 as the yardstick against which they compare their returns on stocks. The long-run return from index funds is higher than can be expected from almost any other investment. By investing in a broad-based index fund, investors will almost surely do better over the long run than by investing in individual stocks or in a managed mutual fund. A managed mutual fund is one in which the managers adjust the mix of stocks and move often in and out of the market to try to generate the highest total return.
Money Market Funds
One type of mutual fund, called a money market fund, normally uses investors’ funds to buy the short-term debt of businesses and banks. Most of these funds allow investors to write checks against their account. Any check, however, must be above some minimum amount, usually $500. The investor then earns interest only on the amount left in the account.Banks and savings and loan associations offer a similar service, called money market deposit accounts (MMDAs). A major advantage of MMDAs is that the federal government insures them against loss. Mutual funds and money market funds are not insured by the federal government.
Bull and Bear Markets
When listening to news about the stock market, you may have heard the terms “bull market” and “bear market.” A bull market refers to a period of time when stock prices move up steadily. Investors expect this trend to continue, and they buy stock. In a bear market, stock prices have been dropping for a period of time, and investors sell stock in expectation of lower profits. This famous bull statue stands near Wall Street in New York City.
Securities markets are heavily regulated to protect investors.
Economics & You Do you feel more comfortable investing, knowing that the federal government is able to regulate the stock market? Read on to learn about some of the laws controlling the stock market.
The stock market is heavily regulated today, at both the state and federal levels. The Securities and Exchange Commission (SEC), created by the Securities Exchange Act of 1934, is responsible for administering all federal securities laws. It also investigates any dealings among corporations, such as mergers, that affect the value of stocks.
Congress passed the Securities Exchange Act in an attempt to avoid another stock market crash like that of 1929. The act requires that, to inform investors, any institution issuing stocks or bonds must file a registration statement with the federal government. Also, a briefer description, called a prospectus, must be given to each potential buyer of stocks or bonds. It lists the amount offered, the price, and the company’s projected use for the amount raised by the stocks or bonds.
States also have securities laws. These are designed to prevent schemes that would take advantage of small investors.
- stockholders: people who have invested in a corporation and own some of its shares of stock
- capital gain: increase in value of an asset from the time it was bought to the time it was sold
- capital loss: decrease in value of an asset from the time it was bought to the time it was sold
- tax-exempt bonds: bonds sold by local and state governments; interest paid on the bond is not taxed by the federal government
- savings bonds: bonds issued by the federal government as a way of borrowing money; they are purchased at half the face value and increase every 6 months until full face value is reachedomic Analysis
- Treasury bills: certificates issued by the U.S. Treasury in exchange for a minimum amount of $1,000 and maturing in a few days up to 26 weeks
- Treasury notes: certificates issued by the U.S. Treasury in exchange for minimum amounts of $1,000 and maturing in 2 to 10 years
- Treasury bonds: certificates issued by the U.S. Treasury in exchange for minimum amounts of $1,000 and maturing in 30 years
- broker: person who acts as a go-between for buyers and sellers of stocks and bonds
- over-the-counter market: electronic purchase and sale of stocks and bonds, often of smaller companies, which often takes place outside the organized stock exchanges
- stock market indexes: measures of what is happening to a given set of stock prices for a specified list of companies; the most well known is the Dow Jones Industrial Average
- mutual fund: investment company that pools the funds of many individuals to buy stocks, bonds, or other investments
- money market fund: type of mutual fund that uses investors’ funds to make short-term loans to businesses and banks