[Please note the website disclosure statement, which governs my first ever post on stocks and bonds.]
To have a finance blog requires starting with the basics. If we want to build a foundation for our mountain of knowledge, we cannot start at the summit. So what more fitting of a first post than a journey covering the basics of stocks and bonds. Now, rather than putting you to sleep, I will do my best to try and make this as entertaining as possible, as my goal is to demystify finance!
Stocks and Bonds
Enough with the fluff: You have decided to embark on the journey of mastering your finances. That means learning how to invest, but you want to learn the basics before putting your hard-earned moola to work. Good for you! Now you likely have heard the best way to invest is through stocks and bonds, but what are stocks and bonds?
Simply put, stocks make you the boss, and bonds are I owe you notes. Stocks represent ownership in a company, and for every piece purchased, the more of the company you own. These company pieces are known as a share, which is a simple fraction of the company ownership.
ABC Company is made up of 100 shares that it created; these represent ownership in ABC. The founder, Jim, initially owned all 100 shares. Jim now decides to sell 49 of these shares to his neighbors at $1,000 each. Hence ABC is worth 100 shares * $1,000 = $100,000. This $100,000 is the market value of ABC, also known as its market capitalization. Market capitalization is a fancy way to describe how much a company is worth and is often abbreviated to market cap.
Now stock prices change due to many factors, but the biggest one is expectations of what the future holds for that company. If Jim tells his neighbors that ABC company has poor sales and is unsure if they will improve, most neighbors will no longer be willing to pay $1,000 per share. So whatever the neighbors collectively are willing to pay per share now, let’s say $700, is the new price.
In the real world, Jim’s neighbors happen to be the stock market, which consists of anyone who wants to buy and sell a given stock.
Further building on our example, let us say that Jim wants to change the company’s focus (what the company does to make money). To do this, Jim needs a majority of the stock owners to agree with his decision. Since Jim owns 51 shares, he holds a majority and thus can decide what to do with ABC Company’s focus. What if Jim only owned 10 shares, though? Then Jim would need to convince enough owners to agree with him, and in the world of finance, this is referred to as voting with him.
Thus owning a stock translates to ownership in that company and the power to make decisions. So the more shares you have, the more control you have! The more control you have, the more influence you have in driving the company’s decisions.
But what about profits? If I am one of the bosses, shouldn’t I be entitled to some of the profits? You most certainly are! For stocks, profits are shared with owners through dividends and or the price of the stock.
The word dividend derives its origins from the Latin word dividendum, which means “thing to be divided.”1 Thus a dividend is your portion of a company’s profit that has been divided up and sent directly to you. The reason for this is because every owner is entitled to some of the profit, so it must be divided and allocated amongst all shareholders. Now some companies reinvest their earnings to make the company worth more for owners, rather than issuing dividends. In this case, you profit by the increased share price when you sell your ownership.
While there is plenty more to learn about stocks, that is not the focus of today’s post. Instead, today’s post is meant to give you the basic knowledge needed to be an investor; thus, we shall move onto bonds and why you are the bank if you are a bondholder. After all, banks are the ones who generally issue I-Owe-You’s!
If stocks are ownership, then bonds are a fancy way of saying I-Owe-You.
Bonds indicate that someone has borrowed from another person or party, just like how banks lend money to people to buy houses. What does this I-Owe-You note mean, though? The origins of the word bond stem from the English word band. Band traces its meaning to “anything that binds, which is a fancy way of saying things are connected.”2
As a result, bonds bind two people or parties together through an I-Owe-You note. One party lets the other borrow money but in return expects to receive their money back plus a profit, which we will refer to as a payment of interest.
Make sense so far?
Now in the world of investments, bonds come in two primary flavors: Government and Corporate. The reasons vary as to why governments or companies would want to borrow money. However, borrowing usually funds a project or expense that the issuer cannot pay for on its own until the future without this I-Owe-You note. The implication of this is that bonds are a debt to another party, not ownership.
Bonds are issued when participants agree on how much should be borrowed and at what cost (i.e., interest). The money is then lent out and not repaid until an agreed-upon date in the future. Still, as a sign of goodwill, the borrower will pay interest payments to the lender each year, usually through one in the spring and one in the fall. Once the money is paid back, the parties are no longer bound together through their contract, and it expires.
Inevitably some of the people who lent out money will need it back before the contract is up. To do this, they must sell their ownership of this I-Owe-You note, similar to how stock owners sell their shares. Thus the bond market is created, and it is just like the stock market but instead used to sell bonds (or buy them)!
1. Bonds are borrowed for an agreed-upon amount. This borrowed amount is known as the par value, and it is repaid at the agreed-upon date in the contract.
2. In the bond market, people may be willing to pay more or less than what your I-Owe-You note says. This negotiated price is called the market value.
3. The market value is determined by current interest rates, the time left before the repayment, and the likelihood that the borrower will pay it back.
Market value is a subject that I could devote an entire post to (and someday I likely will); for now, all you need to remember is that bond prices move opposite to current interest rates.
If interest rates go up, bond prices go down. If interest rates go down, bond prices go up.
$1,000 bond pays $50 in interest each year, hence it pays 5%
$50 / $1,000 = 5%
Interest rates go up to 10%, and you want to sell your ownership of the bond. To do this, you have to be competitive with other sellers; being competitive means matching your interest rate to that of other interest rates being offered. To do this, you have to lower the price of your bond, thus increasing its interest rate; lowering the price is as simple as selling the bond for less than the borrowed amount.
10% = $50 / X
X = $50/10%
X = $500
This is a dramatic example to illustrate the concept and doesn’t factor in time, nor does it factor in the risk that the borrower may not repay it, but I hope it was illustrative!
So why are bonds considered to be safer than stocks? There are many reasons, but the two leading causes are that 1. Bonds put you at the front of the line to get repaid if the company runs out of money, and 2. The company guarantees that it will repay you at the end of the contract. These two reasons mean that you are likely to get your money back, which cannot be said about stocks.
With stocks, you are the last person to be paid out if a company goes bankrupt, plus no one is guaranteeing how much the company will be worth in the future. Stocks are only ever worth how much the next person is willing to pay! As a result, retirees are often told to use bonds because they are safer and have more guarantees than stocks. These guarantees make bonds less speculative than stocks, where it is always a question of what will happen next.
At the same time, these guarantees are why bonds generally return less money to investors because they are safer. The more risk you take, the more reward you should receive. This risk is why stocks tend to be viewed as more favorable investments for those in pursuit of more significant gains.
I hope this introductory post helps you better understand the basics of stocks and bonds! Are you someone who would invest in both stocks and bonds, and what is your reason for doing or not doing so? Let me know what you think in the comments below, and be sure to read my next article on funds, which are another way to own stocks and bonds!
Mile High Finance Guy
finance demystified, one mountain at a time
I was wondering what platforms one would go to in order to buy bonds in a company?
Namely, I’d be in trying out (low stakes) capital structure arbitrage where I might long/short bonds and take the opposite position in the other if they’re mispriced relative to each other.
I believe you can buy company bonds from most discount brokerages, such as Fidelity & Schwab. I have never done so myself, though. So, I am not entirely sure as to the process. What inspired you to look for pricing inefficiencies?