Stocks and Bonds Decoded

I’ve always wondered by the bright folks on wall street decided to create ten different names for the same item, and why Fox and CNN decided to create five more. Trying to decode wall street terminology can be a daunting task. Unfortunately, too many financial advisors assume that most people are familiar with financial terms, but never take the time to explain them. Clients, seeing that they are expected to know this information may be too embarrassed to ask, and just sit there and nod their heads, never having a clear understanding of what is being explained to them.

Below, I have listed a couple of the more common phrases/words used in the financial services industry, with synonyms and definitions of each.

Common Stock (aka Equities, Common Shares, Stock Certificates)

• When an investor owns stock in a company, he/she technically owns a fractional piece of that company (although this percent ownership is usually very small, as a majority of the shares are either held by the company itself, or large institutions). Ownership in the company has several perks, including the ability to vote on changes to the company’s board of directors at the annual meeting every public company is by law required to hold. Again, while each share is given one vote, because most shares are held by large institutions, it is typically the desires of that company that get implemented, not the wishes of “the little guy.”

  The value of a stock is determined by the market, based on the rules of supply and demand. If most people want to buy the stock, the price goes up. If most people want to sell the stock, the price goes down. While some people try to predict patterns in the future movement of a stocks’ price (often referred to as technical analysis), the future price of a stock is mostly undetermined, and there are no guarantees the value of a company’s stock will increase, or for that matter decrease, over any time period by any set amount.

An important point I want to make about common stock: Some people believe that when you purchase a share of stock, for example, General Electric, that the company actually receives the money that you paid for that stock, and is able to then invest that money. This is not accurate. Aside from a company’s IPO (initial public offering, which will be discussed in a future post), most, but not all, transactions take place between two investors.

What I mean by that is when you buy a share of GE, you are buying it from someone just like yourself (well, maybe not EXACTLY like you, but you get what I mean), who has decided for whatever reason they did not want to own that share of GE anymore and decided to sell it. The purchase price of the stock, paid by you, goes to that other investor (typically less a commission charged by whatever firm you use to complete the transaction).

Stay tuned for a future discussion about the difference between common shares, discussed above, and preferred shares, which are a strange combination of common shares and bonds, which are discussed below.

Bonds (aka Fixed Income Securities, Debentures, Notes, Loans)

• A bond, unlike a stock, does not carry with it ownership rights in the company. This is a very important difference. A bond is basically a loan that is taken out by the company, financed by you, the investor. In return for this loan the company this money, the company agrees to pay a coupon (interest) payment on an annual/semi-annual basis (unless it is a zero-coupon bond, to be discussed later). Bonds are usually issued for a fixed term, for example 5 years. At the end the term, the company agrees to pay back the amount that you, the investor, has loaned to it. Most bonds are issues in $1,000 increments.
  
  Unlike equity investments, returns on fixed income securities are generally fixed if you hold the bond to maturity (the end of the loan term), pending the ability of the company to pay back its loans. On a bond that pays 5% interest, you can expect to earn $50 per year. At the end of the loan term, you can expect to get the face value (your $1,000) back. Additionally, fixed income investors rank higher on the food chain in the event of a company bankruptcy. In the event of a company bankruptcy, the company will pay off all of its debts, including those to bond holders, before it returns any money to its equity investors.
  
  Comforting, isn’t it? So why wouldn’t everyone just buy bonds? The answer lies in the risk-reward trade-off. Generally, as the riskiness of an investment increases, so to does its potential return (and potential loss). Because a bonds return is much more predictable, and because the return of your investment is more likely, it inherently has less risk than a stock which has a very unpredictable return, and therefore more risk. As such, stocks have historically generated a return greater than that of bonds over large periods of time (the last 10 years not being one of them).

Stay tuned for future discussions on different types of bonds, including zero-coupon bonds, floating rate bonds, and convertible bonds, among others.

I hope that this post has helped shed some light on the terms used to describe different investment types. Education is a core component of the approach we take with our clients, and is an on-going process. If you have any questions, would like a topic discussed in more detail, or think that other terms should be included, let me know in the comments and I will either reply directly or create another post to answer!