Stocks, Bonds, Dividends: A Beginner’s Guide
Individual investors’ astounding rush into stocks and bonds during the past year has frequently been a “shoot first, ask questions later” affair: You send your money, then you wonder what exactly it is that you bought and how to understand it.
If stock and bond market terminology remains largely a mystery to you--because you’ve never stopped to learn the basics--the following primer should help.
In capsule form, here are answers to some of the most common investment questions. Other such primers will follow periodically in Market Beat.
If some of these are obvious, consider sharing them with your spouse, children or friends who may be new to investing.
* What’s the difference between stocks and bonds?
A share of stock represents direct ownership of a piece of the company that issued the stock. A company makes no promises when it sells stock. There’s no assurance the share price will rise.
In that sense, stocks represent the ultimate expression of capitalism: You’re putting money into something with absolutely no guarantee you’ll ever get a penny back. Your bet is that the stock will rise if the company prospers over time and its earnings grow--thus making your slice of ownership worth more.
A bond, on the other hand, is essentially an IOU from a company or government entity, rather than a share of ownership. You give the borrower, say, $1,000, and the borrower agrees to pay it back after a set number of years. In the meantime, the borrower agrees to pay you a set amount of interest each year--6%, 7%, whatever--for the use of your money.
* So a bond is guaranteed to pay some sort of return, while stocks aren’t?
Correct. But bonds aren’t necessarily foolproof. If a company gets into financial trouble, it may stop paying interest on its bonds. And if a company fails altogether, bond owners can lose the original sum they lent to the company, or some portion of it. But the financial rights of bond owners always come before those of the stock owners.
In practice, the vast majority of bond issuers make good on their payments.
* If bonds are safer, why buy stocks?
Because stocks offer the potential for far greater return. Say Company X raises money by issuing stock and also by issuing bonds. If the company introduces some hot new product, and its earnings soar, the stock is likely to soar as well because it represents direct ownership of the company and its growing assets.
The company’s bonds are merely an IOU, not a slice of the pie. If they guarantee to pay the owners 7% a year, that’s all they’ll pay--no matter how successful the company might become.
* When I buy a stock or bond, does the issuer automatically get that money?
Only if you’re buying the securities directly from the company, in the initial offering. Once a stock or bond issue is sold, and the securities begin trading in the open market, the buyers and sellers exchange money among themselves--the company doesn’t participate.
To illustrate: Company X issues 10 million shares at $10 apiece. The $100 million goes directly to the company. After that, whenever the shares trade, a buyer is paying cash directly to a seller for his or her shares. If you bought at $10 a share from the company last year, and investors now are willing to pay $15 for the stock, you can sell for $15--thus earning a $5 profit on your original purchase. The company doesn’t share in that.
* Then why should a company care if its stock goes up?
A rising stock price naturally gets attention and increases the likelihood that more investors will want to buy the stock. That makes it easier for the company to issue new shares--providing fresh cash with which to expand the business. You can see how success often begets more success for companies that issue stock.
* If a company increases its earnings by selling more goods each year, how do shareholders benefit directly?
Mostly through cash dividends. Many companies pay a certain percentage of their annual earnings to shareholders in the form of dividends. Payments are usually made four times a year. It’s a way of sharing the company’s success with the ultimate owners, though a company isn’t obligated to pay a dividend.
* How big a cash dividend do shareholders typically earn?
That varies. Older, larger companies usually share more of their earnings with stockholders. Younger firms share less, preferring to retain more of their earnings to reinvest in the business.
As an example, IBM pays an annual cash dividend of $4.84 on each share. If you own 100 shares, you earn $484 a year in dividends.
Apple Computer, a smaller company than IBM, pays an annual cash dividend of just 48 cents a share. That’s $48 a year if you own 100 shares.
* What does “dividend yield” mean?
It’s a simple measure of your dividend return, expressed as a percentage. IBM’s stock closed Friday at $96.375 a share. Because the annual dividend per share is $4.84, your return from dividends is 5% a year (divide $4.84 by $96.375 to get 5%). So IBM pays a 5% return just for owning its stock.
In contrast, Apple’s 48-cents-a-share dividend, divided by its Friday stock price of $64.75, means that the dividend yield on that stock is just 0.7%.
* Wouldn’t you want to own the company that pays a bigger dividend?
Not necessarily. Even though Apple pays a smaller dividend, its stock price has risen much more than IBM’s in recent years, because Apple has been growing faster than IBM.
When investing in a stock, you have to judge your expected return from dividends and from the stock’s potential to rise in value. In most cases, the potential gain from the stock price will be much more dramatic than what you may earn in dividends. Apple stock, for example, soared 31% last year.
In the bull market that has been going on for the past year, it’s probably fair to say that most investors have been buying stocks not for their dividends, but for the likelihood that stocks will be worth more in the years ahead as the economy slowly recovers from recession and companies grow.
Stock Exchange or NASDAQ?
Stocks of most American companies trade in one of two places: On a stock exchange, such as the New York Stock Exchange or Pacific Stock Exchange, or in the over-the-counter market, often called the NASDAQ. Here’s a brief look at the differences:
Traders on NYSE floor * The exchanges: A stock exchange, such as the NYSE, is a physical place where traders gather to buy and sell stock on behalf of clients. If a stock trades on the NYSE, one person ultimately is responsible for maintaining the price of the stock at all times: the “specialist,” whose job is to keep an orderly market in the stock, matching “buy” and “sell” orders from traders across the nation.
The specialist is essentially a traffic cop; the actual price of a stock throughout the day is determined by simple supply and demand. The highest bidder at any moment gets the shares and thus sets the new price.
Because millions of shares of a stock may change hands in a day, specialists could never physically handle all trades. So most smaller buy or sell orders are automatically executed by the exchanges’ computers at the prevailing prices as marked by the specialist.
The exchanges, led by the NYSE, have traditionally been home to stocks of most of America’s biggest companies.
* The over-the-counter market: This market isn’t a physical place but rather a network of brokerages connected electronically nationwide. The connection is handled by the National Assn. of Securities Dealers Automated Quotation system, or NASDAQ.
Unlike at exchanges, there are no “specialists” maintaining order in individual NASDAQ stocks. Rather, traders can see on computer terminals the prices at which other traders are willing to buy or sell a particular stock at any moment. A broker looking to buy or sell an over-the-counter stock for a customer thus chooses the best price from among a competing network of traders nationwide.
Like the exchange system, NASDAQ is largely automated for smaller investors’ orders: The NASDAQ computer automatically finds the best price quoted on the system and makes the trade.
The over-the-counter market has traditionally been the home of smaller, younger companies. However, the debate over which is superior--an exchange or NASDAQ--has raged for years and probably will go on forever.
