There are two broad categories of securities available to investors: equity securities, which represent ownership of a part of a company and debt securities, which represent a loan from the investor to a company or government entity. Within each of these types, there are a wide variety of specific investments. In addition, different types can be combined (e.g., through mutual funds) or even split apart to form derivative securities.
Each type has distinct characteristics plus advantages and disadvantages, depending on an investor’s needs and investment objectives. In this section, we provide an overview of the most common classes of investment securities you can try.
Stocks
The type of equity securities with which most people are familiar is stock. When investors buy stock, they become owners of a “share” of a company’s assets. If a company is successful, the price that investors are willing to pay for its stock will often go up and shareholders who bought stock at a lower price then stand to make a profit. If a company does not do well, however, its stock may decrease in value and shareholders can lose money. The rise in the price of a stock is termed appreciation or “capital gain.” The stockholder is also entitled to dividends, which may be paid out from the company.
Investors, therefore, have two sources of profit from stock investments, dividends, and appreciation. Some stocks pay out most of their earnings as dividends and may have little appreciation. These stocks are sometimes referred to as income stocks. Other stocks may pay out little or no dividend, preferring to reinvest earnings within the company. Since all of an investor’s potential earnings comes from appreciation these stocks are sometimes referred to as growth stocks. Stock prices are also subject to both general economic and industry-specific market factors. There is no guarantee of a return from investing in stocks and hence there is risk incurred in investing in this type of security.
As owners, shareholders generally have the right to vote on electing the board of directors and on certain other matters of particular significance to the company. Under the federal securities laws, most companies must send to shareholders a proxy statement providing information on the business experience and compensation of nominees to the board of directors and on any other matter submitted for shareholder vote. This information is required so that stockholders can make an informed decision on whether to elect the nominees or on how to vote on matters submitted for their consideration.
Stock investments are typically common stock, which is the basic ownership share of a company. Some companies also offer preferred stock, which is another class of stock. Preferred stock typically offers some set rate of return (although it is still not guaranteed), and pays dividends before dividends are paid for common stock. Preferred stock may not, however, participate in as much upside as common stock. If a company does really well, preferred stockholders may receive the same dividend as any other year while common stockholders reap the rewards of a great year.
Corporate Bonds
The most common form of corporate debt security is the bond. A bond is a certificate promising to repay, no later than a specified date, a sum of money which the investor or bondholder has loaned to the company. In return for the use of the money, the company also agrees to pay bondholders a certain amount of “interest” each year, which is usually a percentage of the amount loaned.
Since bondholders are not owners of the company, they do not share in dividend payments or vote on company matters. The return on their investment is not usually dependent upon how successful the company is. Bondholders are entitled to receive the amount of interest originally agreed upon, as well as a return of the principal amount of the bond if they hold the bond for the time period specified.
Companies offering bonds to the public must file with the SEC a registration statement, including a prospectus containing information about the company and the security.
Government Bonds
The Government also issues a variety of debt securities, including Treasury bills (commonly called T-bills), Treasury notes, and Government agency bonds. T-bills are sold to selected securities dealers by the Treasury at auctions.
Government securities can also be purchased from banks, government securities dealers, and other broker-dealers.
Similar to corporate bonds, these bonds pay interest and the amount of principal at maturity. Some bonds, such as Treasury Bills, may not pay cash interest. Instead, the bond is purchased at a discount and the interest is built into the amount the investor receives at maturity. Contrary to popular belief investors must pay income tax on government bond interest.
Municipal Bonds
Bonds issued by states, cities, or certain agencies of local governments such as school districts are called municipal bonds. An important feature of these bonds is that the interest a bondholder receives is not subject to federal income tax. In addition, the interest is also exempt from state and local tax if the bondholder lives in the jurisdiction of the issuing authority. Because of the tax advantages, however, the interest rate paid on municipal bonds is generally lower than that paid on corporate bonds.
Municipal bonds are exempt from registration with the SEC; however, the MSRB establishes rules that govern the buying and selling of these securities.
Stock Options
A stock option is a type of derivative security and refers to the right to buy or sell something at some point in the future. There are a wide variety of these specialized instruments such as futures, options, and swaps. Most are not appropriate for the average investors. The type of options with which we are concerned here are standardized, exchange-traded options to buy or sell corporate stock.
These options fall into two categories:
“Calls,” which give the investor the right to buy 100 shares of a specified stock at a fixed price within a specified time period, and
“Puts,” which give the investor the right to sell 100 shares of a specified stock at a fixed price within a specified time period.
While options are considered by many to be very risky securities, if used properly they can actually reduce the risk of a portfolio. Generally, if you are bullish on a stock (i.e. you expect the price to go up), you buy a call option.
The price you pay is called the premium. You would purchase a put option if you are bearish on a stock (i.e. you expect the price to go down). If the stock moves in the right direction you can profit handsomely. If it doesn’t you lose the premium that you paid. Buying puts and calls is not a risky strategy, but selling puts and calls is. One exception is selling a call option on a stock you already own. This is known as a “covered call.” This actually reduces the overall risk of your portfolio in exchange for you giving up some of your upside.
Mutual Funds
Companies or trusts that principally invest their capital in securities are known as investment companies or mutual funds. Investment companies often diversify their investments in different types of equity and debt securities in the hope of obtaining specific investment goals. When you invest in a mutual fund, the fund invests in individual equity and debt securities. There’s no need to make individual purchase and sale decisions. Mutual funds also provide an easy way to diversify a portfolio. Rather than purchasing 50 stocks yourself, you can purchase a single mutual fund.
