A stock is a financial asset that represents an ownership share in a corporation. As a holder of a company’s stock, you are entitled to a claim on the corporation’s assets and earnings. How much of the corporation’s assets and earnings you own depends on the number of shares you bought relative to the number of outstanding shares. Thus, the more shares you own, the larger portion of the company’s assets and earnings you have claim to.
There are two types of shares – common shares and preferred shares. As a common shareholder, you are entitled to a pro rata share of any monies that the company pays out and you have the right to vote on important matters.
The second type of shares is preferred shares. As a preferred shareholder, the dividend payment is fixed at a definite amount and is paid before common stockholders. This differs with common shareholders as dividend payments are not guaranteed. Preferred shareholders also have priority over common stockholders on earnings and assets in the event of liquidation.There are two ways in which you can earn money by investing in stocks:
The price of a stock is governed by the laws of supply and demand and will rise when the quantity demanded exceeds its supply. The second way in which you can earn money is through dividends. Companies distribute dividend payments as a way of sharing their profits with their shareholders. Dividends are usually in the form of cash whereby the company pays a certain percentage of profits to all shareholders.
A bond is similar to a loan that the buyer, or bondholder, makes to the bond issuer. Bonds are issued by companies and government bodies to fund their day-to-day operations or to finance specific projects. When an investor buys a bond, he or she is, in fact, lending money for a certain period of time to the issuer of the bond. In return for lending funds, investors receive the principal amount back, with interest, at the time the bond comes due or “matures”.
For example, you decide to purchase a bond with a face value of $1,000, a semi-annual coupon of 8%, and a maturity of 10 years. What does this mean?It means that:
The coupon payment on each of this bond $40 = $1,000*(8%/2). This means that you will receive $40 every six months.
Cash flows to be received over bond’s life
Just like stocks, the price of bonds will fluctuate throughout the trading day and its lifetime/holding period. Bond prices fluctuates with changes in interest rates. Interest rates and bond prices have what is called an "inverse relationship" – meaning, when one goes up, the other goes down.
Over the long term, stock markets have performed well, however, there is no guarantee that the past will be repeated in the future. When you purchase a stock, there are no guarantee that you will make money on your investment. The price of a stock is determined by the forces of demand and supply and both factors are largely driven by the company’s financial performance. In addition there is no guarantee the stock’s price will go up, there is also no guarantee that the company will pay dividends, or even stay in operation.
As an investor, there is also the possibility that you may lose all your money – a situation that is often common when the stock market falls steadily, with the stock price trading below your initial acquisition cost.
If you hold the bond to maturity and it is a coupon paying security, you will receive this fixed coupon payment for the length of the security’s tenure. While this payment is fixed, there are inherent risks associated with investing in bonds and they include:
Different types of assets have different risks. For example, bonds have the safety of periodic income via coupon payments, however as a stock holder, you gain the benefit of being a partial owner in the company and share in the unlimited potential when the stock price rises.
If you purchase one asset and it performs poorly, there is a chance that you can lose all of your investment. However, if you purchase a variety of investments – there is the possibility that some investments will perform badly while some will earn you money. Thus, the profits you earn on those investments that are posting positive returns can be used to offset the losses on those investments that perform badly. This is the key concept of diversification – to reduce the overall risk of your investment.Diversification can be achieved in many ways:
Asset allocation is an investment strategy that involves spreading your funds across various asset classes such as stocks, bonds and cash and cash equivalents. The importance of dividing your money in various asset classes is to reduce investment risk. Investment risk is reduced by investing in assets that do not have the same risk and return characteristics, meaning they do not respond in the same way to the same market forces at the same time. Ideally, if one particular asset class is underperforming or incurring losses, another asset class should be posting gains, thus netting off or reducing the size of the losses.
Risk tolerance is an assessment of how much risk an investor can handle and is critical in determining how much money can be invested into a particular investment.
Stocks are very volatile and have the highest potential return, but they also have the highest risk. Cash equivalents that include Treasury bills / Government Treasuries have the lowest risk since they are backed by the government, but they also provide the lowest potential return.
Investors who have the ability and disposition to tolerate fluctuations in value will be more inclined to invest in stocks. In contrast, investors with a low tolerance for wide swings in value will prefer bonds and money market securities.An investor’s risk tolerance is determined by the following factors:
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