FINANCIAL LITERACY MONTH: STOCKS & BONDS

For many, finances are an ‘off-limits’ conversation, and yet, we need to make big, important financial decisions at various times in our lives.  Even those small financial decisions can have a big impact if not handled thoughtfully.  But if financial literacy is not a national requirement in our school systems, and our parents may (or may not) want to discuss finances with us growing up, then how do we learn?

Gaining knowledge of simple, foundational financial concepts is a key component of financial literacy, ultimately leading to smart financial decision making, and financial prosperity.

In this article, our ATLAS Lifestyle Planning Group (LPG) Partner, Michael Abbate, shares his insight and experience with Stocks and Bonds, to help you prepare for future financial decisions involving these types of investments.

 

The Difference Between Stocks and Bonds

Simply stated, stocks and bonds are two ways for companies to raise capital for business operations.

Stocks give the investor (you) a “share” of ownership in a publicly traded company.  If the stock value increases, and you choose to sell your share while value is high, you may experience a profit (selling your share for more than the purchase price.)  If stock value drops, and you choose to sell while value is down, you may experience a loss (selling your share for less than the purchase price.)  The hope is, of course, to sell while value is high and turn a profit on your investment.

Bonds act as a “loan,” provided by the investor (you), to a company for a specified period.  When the time is up, the money is returned to you;  and in the meantime, the company pays you a percentage on that “loan” providing a return (profit) on your investment.

 

Understanding Stocks

Privately held companies needing to raise money for business growth will go through, what is called, an Initial Public Offering, or “IPO.”  This refers to the timeframe during which a private company sells shares to the public for the first time, enabling the company to be known as a publicly traded company with investors.  Following the timeframe of the IPO, regular investors can begin buying and selling stocks of this company through the stock market exchange.

When added to the stock market exchange, the now publicly traded company’s name will be shortened to, what is known as, a “ticker.”  For example, Apple’s ticker is AAPL, and Ferrari’s ticker is RACE.

Market Capitalization, shortened to “Market Cap,” refers to the size and market value of a publicly traded company.  To determine the market cap, multiply the current price of one share of stock, by the number of outstanding shares.  Bear in mind, stock share prices move up and down in monetary value, thus altering a company’s market cap over time.  Stock prices may ebb and flow based on a myriad of factors – the company reported financial performance, supply and demand, economic conditions, and more.

It is often said of the stock market:  Buy low and sell high.

This rule of thumb comes in handy when considering supply and demand.  Stock price per share may increase if the stock is in high demand with low supply (ie. there are more investors wanting to buy stock, than the number of sellers giving up their shares.)  Stock price per share may drop if the stock is in low demand with a lot of supply.  At that point, the price of stock shares generally decreases, which typically brings in more buyers.  Though it can sometimes be a smart move to buy low (the stock has no where to go but up, right?), it is worth noting the risk of purchasing stock shares when prices per share have plummeted:  A company whose stock drops too low may be removed from the stock market exchange.

Utilizing your own insight, and/or insight from a strategic discussion with your financial advisor, you may decide to sell a stock share, or several.  At that time, depending on the stock share price as compared to your original purchase price, you may collect a profit, experience a loss, or break even.

 

Company Commitments to Stockholders

Companies have an obligation to stockholders to be forthcoming and transparent with relevant information.  Quarterly updates are provided, allowing investors to monitor their investment successes and failures, and make informed decisions about when to buy or sell.  In times of economic uncertainty, companies may not offer guidance, which can negatively impact that stock shares value due to the lack of clarity regarding the company’s finances.

 

Understanding Bonds

Bonds are a way for both corporations and governments to raise operating capital.  When you purchase a bond, you are essentially loaning the value of the bond to the ‘company’ (corporation or government), in exchange for some predetermined amount, which will be paid back to you later.  In issuing bonds, the ‘company’ agrees to pay interest to you, the investor, as the loan matures.  This is how you receive profit on your investment.  Because bonds are highly structured in this way, they are often referred to as “fixed income securities” because, at the time of purchase, you will already know how much income will be earned over the lifetime of the bond.

Bonds are issued for a specified amount of time, in $1,000 increments.  This means, if the price per bond is set at $1, and you purchase 10 bonds of any maturity, then the bond is the equivalent of $10,000.  The price after issue will adjust based on normal supply and demand changes over time.  The price of the bond could be above or below $1 per bond when trading, which is known as trading at a “premium” or “discount,” respectively.

When the period ends – also called, “reaches maturity” – the loan, plus final interest payment, is paid back to whomever owns the bond at that time.  This type of investment provides you a lower risk way of making money from credit-worthy corporations or governments, but generally with a lower return.

To help you decide where to invest, each company issuing bonds has a credit score, just like yours, rating the company’s likelihood of paying off their investor loans.  Companies with a lower credit risk generally pay a lower interest rate to investors.  Companies at risk of defaulting on their loans are generally required to pay a higher interest rate to investors, known as a “risk premium.”

 

So What’s The Difference?

In general, bonds are considered a lower-risk investment than stocks.  Bonds often entice an older demographic of investors;  those close to retirement who need stability in their investments, and more income.

Stocks do not have a known maturity (repayment) date, therefore carrying some uncertainty.  Additionally, stocks are associated with long-term growth and short-term uncertainty, known as “volatility.”  At times, stocks may see drastic drops in price.  They will need time to recover – not only to break even, but to ultimately profit.  Therefore, it is typically the younger demographic of investors who are more comfortable with fluctuations in stock share prices.  They may be decades from retirement, meaning they have time for long-term investments, stock prices to recover, and to sell with a high profit margin.

The higher risk with stocks may also result in higher returns, but it is a gamble as the market can be unpredictable.

 

Is One Better Than The Other?

When it comes to investment decisions, the best course of action is always “in the eye of the beholder.”  That is – it’s up to you!

Historically, stocks have had larger long-term growth than bonds.  But bonds may offer more stability.  Regardless of the investment style chosen, it is important to understand the credit worthiness of the companies in which you are investing.  The term diversified portfolio means balancing a variety of investments – a broad mixture of stocks, bonds, risk tolerance and time horizon for the investment.

Maintaining a balanced and diversified portfolio can be challenging, especially for someone unfamiliar with the investment industry.  This is one of the primary reasons why working with a professional financial planner and investment advisor typically provides better outcomes.

As always, ATLAS wants you to feel at ease when handling investments, financial decisions, and in planning for your financial future.  Know that our team of professionals with ATLAS LPG are a resource to help you further understand this, and other challenging topics in the investment space.

For more information on ATLAS LPG, click HERE.