We often talk about “the market” as well as stocks and bonds without much understanding of what those terms mean. Undoubtedly, you have heard about the various market indexes but what exactly are those and are they at all relevant to your financial plan? You have probably also heard about your ability to buy and sell stocks and bonds but only have a vague idea of what those things are. So in today’s blog post, I am going to provide you with a brief overview of those terms and their importance to you.
Let’s begin by talking about the two primary markets that you are most likely to have heard of or interacted with. In regards to your investments, the market generally refers to two key stock exchanges i.e. the New York Stock Exchange (NYSE) and the Nasdaq. The NYSE is the largest stock exchange in the world and was started in May of 1792. When you hear people talking about the market or Wall St., generally that is a stand in for the NYSE. The NASDAQ is the second largest stock exchange in the world and was the very first electronic exchange in 1971. It is also located in NYC and has become the exchange of choice for many technology and biotech companies.
So, what exactly is a stock exchange? Well, the exchanges act as the primary marketplace for buying and selling stocks, bonds, ETFs and so on. When a company wants to issue stock in an initial public offering or IPO, the exchanges are where they go to do that. Stocks and bonds can be bought and sold outside of the market between businesses and individuals but the exchanges are where all the action begins. That said, when you hear people saying things like “what did the market do today” or “how has the market performed this year” what on earth are they talking about? Well, the ever-changing values of the companies listed on the exchange, are tracked and monitored by what are called market indexes. In general, the market indexes display the current prices of the stocks or bonds that they track in real time. Different indexes track different stocks but the three most followed indexes are the: S&P 500, Dow Jones Industrial Average (DJIA), and the Nasdaq Composite.
Whether or not an index is relevant to your investment portfolio depends entirely on what you are invested in. For example, the S&P 500 would be a good gauge of your investment performance if you held mainly large company stocks whereas the Nasdaq Composite might be a better option if you had a significant percentage of your holdings in biotechnology companies. It is important to note that while these indexes can give you a general sense of where the economy is heading or how your investments are doing, you should really rely on your own plan and investment strategy for decision making.
By this point, I have mentioned stocks and bonds a few times and that you, an individual, have the ability to buy and sell them but what is a stock or a bond? Let’s start with stocks and how they are bought and sold. Essentially, a stock a very small ownership stake in a large corporation and those small pieces of the company are referred to as “shares”. The price for those shares fluctuates daily based on the supply and demand for that stock. Some of the largest companies in the world like Apple, Tesla, and Amazon all offer stock in their corporation in the form of shares. Your next question is probably why would a company issue stock? After all, they are technically selling away parts of their business by doing so. The reason why companies issue stock is that they offer require capital (i.e. money) in order to grow. Perhaps you have heard the old adage, you need to spend money to make money? That’s exactly what is going on here. The other option businesses have to raise capital is to take on debt which we will get to in a moment. Stocks can be purchased on the exchanges as an IPO but most individual investors purchase stock on the secondary market or between themselves or other businesses on virtual trading platforms. The benefits of issuing stock is pretty simple: It allows you to raise the money necessary to achieve your company’s desired growth while also avoiding taking out any debt and bringing further awareness to your brand. On the con side of the argument is that by issuing stock, you dilute your ownership and risk losing control of the company that you worked so hard to build. You also become beholden to your shareholders at annual shareholder meetings and must endure the added scrutiny of authorities, the general public and financial regulators alike. There are significant pros to issuing stock but companies that do so also take on a lot of risk.
The benefits of owning a company’s stock is also pretty straightforward: If the company grows, so does the value of your shares. Over time, this investment has the potential to grow substantially. In addition, some companies also issue cash dividends to their shareholders that can be taken in cash payments or used to buy more shares. You also have the opportunity to make your voice heard at annual shareholder meetings although unless you are a very large investor, you would probably vote by mail. However, just like you participate in the company’s gains, as a shareholder you also participate in the company’s losses. This means simply that you are at risk of losing money and in some cases losing your investment entirely if the company goes bankrupt. Your investment is also exposed to economic, legislative, and business risks associated with that particular company. So again, owning stocks can be very valuable to you over time but they do not come without their risks. Individual investors can trade (or buy and sell) their shares in the secondary market by using third party trading platforms and trading services online. They can also work with a financial professional to help them make these trades and ensure that they are done correctly.
We have talked about stocks as being one way that companies can raise capital but what about the second way, taking on debt? Companies take on debt by issuing bonds. Essentially, a bond is when a company borrows money to fund their endeavors. Large companies aren’t the only ones who do this. So does the Federal government as well as your state and local governments and municipalities. Bonds have more moving parts than stocks and while we aren’t going to spend too much time on how they operate, I do want to give you a quick glance at the anatomy of a bond. Every bond has a Face value or otherwise known as the bond’s Par value. A bond also has a current price which is what the bond would go for if sold in the secondary market. Like any other debt, bonds carry a stated rate of interest or coupon to be paid by the issuer. The maturity date of the bond refers to when the bond will officially be paid off. Much like how you may have a 15 or 30 year mortgage. The bond’s yield to maturity refers to the return that an investor should expect to receive by owning the bond and bond duration is a calculation that tells us how sensitive a bonds value is to changes in interest rates. And finally, the quality of the bond tells the investor how creditworthy the issuer of the bond is.
I hope that after reading today’s post you feel more confident about what the market, stocks, and bonds mean. If you are interested in learning more about the different types of investments check out our online course called, “Financial Planning Basics”. If you just want to watch the videos on investments and the market, click here.
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal.