Securities constitute the objects which investments are made of. There are various kinds of securities. They are traded in markets, each one with specific rules. This page aims at providing an overview of the securities available to public investors.
STOCKS are the most popular security for investment. They actually represent ownership in a specific company. The ownership of certain companies are divided in a number of stock shares. Therefore, each share represent a tiny fraction of that company. This has three major implications:
- Since each stock holds a tiny fraction of the ownership of the company in question, it holds by itself a right to participate in the decisions of the company. Specifically, companies periodically hold general assembly meetings, where all shareholders have a seat, and where each one of them has the right to vote. Major decisions taken at the general assemblies are the election of the board of directors, that actually run the company on a daily bases, the approval of financial statements, and the decision on the destiny of company profits.
- The net profit accomplished by a company is usually divided among two destinies: investment of the profits on the company, e.g. improve manufacturing technology, expanding, and return to shareholders in the form of dividends. The former may (or may not) contribute to the growth of the company, depending on how the money is managed, while the latter give the shareholders the return of the final implication of owning a company, i.e. to make money. Since each one of these two destinies are profitable to the shareholder in the long run, a major (if not the most important) indicator of the potential of a company is the earnings per share (EPS). This indicator is simply the quotient of the net profit of the company in a year, over its total number of shares outstanding. The EPS is therefore calculated in a yearly basis. In other words, the EPS represents the net profit of the company of a single stock. Not only the last year EPS of a company is important, but also the historic values. A fraction of the EPS is usually given to shareholders in the form of dividends. The ratio of the dividend over the EPS is called the payout ratio.
- When a company files for bankruptcy, since a share of stock represents a tiny fraction of it, shareholders are entitled to what is left of the company. Of course if a company files for bankruptcy, it means lack of financial health, and usually the company belongings do not even suffice to pay all of its debt. But anyway, at least in abstract, if a company were to be dismantled and sold in pieces, each shareholder has the right to get a part of the money, proportionally to the number of shares held. But hostile company takeovers usually take the form of public offerings made by the buying company to buy the victim's stocks at irresistible high prices.
The most common way stocks appear in the market is by operations called initial public offerings (IPO). These happen when a company decides to issue stocks, but giving away part of it to the public, in return for money paid by the new shareholders. The public gains a part of the company, by the cost of paying money for it, while the company obtains a massive amount of money, by the cost of having to give away part of its ownership, as well as part of its profits in the form of dividends.
Outside IPO's, stock can be bought and sold in stock exchanges. These are places (physical or virtual) where stocks are assigned a selling price and a buying price. Anyone can buy or sell stocks, at the specified prices, via brokers, which are the persons authorized to actually perform the transaction.
How are buying and selling prices set? Each party interested in trading stocks issue orders containing the number of shares and the price that are being bought or sold. If there is a selling order and a buying orders at the same price, the transaction is performed, at the specified price, for the most number of shares possible. Otherwise, the orders simply stay there, waiting for buyers of sellers able to meet the prices.
Usually there is a list of selling prices/quantities and a list of buying prices/quantities pairs. On the one hand, if many parties become interested in buying a stock, the standing orders with lower prices tend to disappear, since they become easily bought, therefore only the higher price orders remain, therefore, the selling price of a stock will increase. And on the other, the many parties want to sell their shares, the higher priced buying orders tend to be rapidly satisfied, remaining only the lower ones, and therefore, the buying price will decrease. This leads to the sole factor setting stock prices: demand of stocks. And since this demand is in practice determined by psychological factors, at least in short-term, stock prices fluctuate, usually in a random fashion. Technically it can be compared with the concept of random walk of statistics.
See also Classes of Stock
Companies often need money for various ends, such as improving itself, expanding, buying other companies, and so on. There are many forms of accomplishing this: one is to use money from profits to re-invest, but this only provides a limited amount of money, thus limiting expansion potential; another is to borrow money from a bank, but banks can demand high interests rates, namely if the guarantees provided but the company do not satisfy the bank and/or the risk associated with the lending is high.
A third possibility appears in the form of bonds issued by companies. A bond is a contract between an issuing company and a buyer. In this contract, the buyer lends a certain amount of money to the company, for a certain number of years. In return, the company is obliged to pay interest to the buyer, periodically, at a specified rate.
The number of years for which the money if borrowed to the company is called the maturity. Maturities can range from a couple of years to as much as 50 years, although such large maturities are rare (e.g., Telecom Italia). The maturity contracted is not absolutely rigid; bonds can be called before maturity, meaning that the company has to not only pay back the borrowed money, but also has to pay a premium due to the early termination of the contract.
Bonds are issued at an initial value, the par value, e.g. $1000 USD each unit, or 1000€ each. There is usually a minimum subscription value (e.g. 10 units). At the end of the maturity, the company pays back the exact amount of the par value. However, in the meantime, bonds can be traded in the market. This implies that during the contract, bonds can be bought or sold at prices different from the par one. Regardless for how much the price can fluctuate, at the maturity, the price always converges to the par value. Usually there are two major trends: the price starts at par value, rises/falls until midtime of the maturity, and then converges back to par value, at maturity.
The third variable that characterizes a bound is the interest rate. Periodically along each year (usually in 6 month periods) the company pays interest to the bond buyer. This interest is calculated as the product of the par value by the interest rate. Often this interest rate is fixed by contract (e.g. 5% yearly). However, there are cases where the interest is indexed to some market index. For instance, bond interest linked to inflation exist. This allows the investor protect itself against inflation during the bond period. There are also cases where the interest rate is zero, but the bond is sold below par value (discount). The investor return corresponds to the difference between the discount value by which he buys the bond, and the par value, which is payed back to him at the end of the maturity.
Companies are not the only entities that issue bonds. Government bonds, or Municipal Bonds, can be found everywhere, since it is a quite common mechanism of financing governments. Government bonds, provided that the issuer is politically stable and its public finances are healthy, are safer than common companies bonds.
What happens when companies are unable to honor their commitments? Two situations may occur. One is to default payment of interest, whenever the company financial situation becomes too degraded. The other is when the company becomes bankrupt. However, in this latter case, the bond owners are the first ones to be entitled to compensation, well ahead shareholders. This makes bonds safer than stocks, in the case of bankruptcy.
There is a strong relationship between market interest rates and bond prices. On the one hand, a rise in interest rates makes bonds less attractive, and therefore bond prices fall, since the demand falls. On the other hand, whenever interest rates fall, bonds become very attractive, the demand increases, and the corresponding prices rise. Moreover, with low interest rates, calling bonds become an interesting option to companies, which prefer to save money in future interest to be payed to bond owners, and re-finance with banks (or issue bonds with lower interest rates). In conclusion, bond market and interest rates move in opposite directions.
Funds become an interesting investment tool for everyone who is not interested in wasting time with stock or bond picking, trading, and so on. Investment companies manage one or more funds, where money from many investors is managed by professionals. One investment fund usually holds a portfolio of securities. The decisions to buy or sell those securities are taken by the investment company behind the fund.
The kind of securities held by a specific fund determine its character: stock funds and bond funds manage solely stocks and bonds; there are also mixed funds, which balance the portfolio among many security kinds. There are also other kinds of funds, for other kinds of securities.
Funds divide among two major types: open funds are the ones which can be bought or sold from/to the issuer at any time, during the fund lifetime, and closed funds which are subscribed at the fund creation, and last for the whole fund lifetime (there are mechanisms for a subscriber to give up from a closed fund, at some cost). Open funds give investors the liberty to move more freely among funds, depending on market conditions, but this also implies more volatility in the current fund prices. For instance, major fund subscriptions can force the issuer to buy stocks at unfavorable times (namely at the peak of bull market), degrading the fund performance at the long-term.
Deposits are not quite securities per se, but are included here for the sake of completeness, once it is also a form of investment.
Bank deposits are the most usual form of saving money. There are two major forms of deposits: Checking and Savings. While the former allows moving from/to the account anytime, the latter one requires the money to stay intact in the account, for a certain period, in order for the contracted interest to be earned.
These is virtually no risk in investing on it, unless the bank enters bankruptcy. The price to pay for this maximum safety is the very low interest rates. They are often comparable with the inflation rate, meaning that an investor can actually lose money, in terms of purchase power. Therefore they are seldom interesting investment options.
Exchange Traded Funds - are a relatively new innovation. They are a basket of stocks (like a mutual fund), but can be bought and sold like an individual stock. The advantages to ETF's over mutual funds are significantly lower management fees, and an ability to "time" your capital gains or losses. The disadvantages are that if you invest $50 a paycheck, your trading costs can be higher because you're paying for a trade every two weeks!