Basics of Stocks and Bonds

In this video I give you an overview of stocks and bonds.

VIDEO SUMMARY:

I wanted to make this video, because I want to ensure that everyone understands the basics of stocks and bonds before we move on to some of the more advanced financial topics. Stocks and bonds are a type of asset class. Asset classes are basically just a category of investments that have similar characteristics. So asset classes might be real estate. They might be precious metals. They could be derivatives. They could be currencies. But stocks and bonds in most portfolios are the most popular asset classes. Stocks and bonds are also a major way that companies raise money.

So let’s talk through an example to show you how this works. Let’s say a company wants to build a new factory, and this factory is going to cost them five hundred million dollars. Now they have a good business case to build this factory. If they build the factory, it will increase their capacity. They’ll be able to build more products. They’ll be able to sell more products, and they’ll be able to generate more revenue. So the factory will have a high return on investment (ROI). With this business case, the business can go out to the financial markets and raise money for this expansion. They can do this by issuing stocks or bonds. There’s a couple of reasons they might do this. They may not have cash in the bank. They may not have the five hundred million dollars lying around. Or they may just do this as a strategy.

Let’s talk a little bit more about the specifics of stocks and bonds. Stock is an ownership interest in the company. So when you own a share, you are actually owning a percentage of that company. You may have heard the term “market capitalization.” Market capitalization means that depending on the price of stocks in the market, those prices inform us about the perceived value of the company. So mathematically you would take the share price times the number of outstanding shares. That should give you the perceived value of the company. So if you own one percent of the shares of the company, the value of your shares is the overall value of the company. One percent of that value should be how much someone is willing to pay you for those shares of stock. I will show you a diagram of how this works. You have the company. The company wants to issue stock so they go to an investment bank. They issue stock for a certain percentage of the company. The investment bank gives them the funds. The five hundred million dollars for the factory. Once those stocks are issued, they can then be traded on the secondary market and this is what most of us are familiar with… the buying and trading of stocks. This trading activity sets the stock price from what people in the market think is the perceived value of the company. That market price informs back on the company, which dictates strategic decision-making, and it impacts their ability to raise funds in the future.

Bonds are a little bit different. Bonds are essentially debt. It is the company going out and getting a loan from the bank. So they will actually set up an agreement with set interest and principal payments, and they will raise the five hundred million dollars. They are agreeing to pay back the amount over time. Once that loan document is set up, just like stock, those bonds can actually be traded in the market, and whoever holds that bond is the person who receives the interest payments.

So let’s move on to the major difference between stocks and bonds. The major difference is that stocks are riskier than bonds and this is really the main takeaway. There are two major reasons for this. When you have a bond, you have this set agreement and you have a set payment amount that you know you are going to make every month, or every period. With stocks you may or may not get paid. It’s not a set payment. Stock is a percentage ownership and so it’s really a percentage of the profits. But the company may or may not make profits. They may make a small amount of profit or a large amount. There is risk there that is not there in bonds. Even though the company makes profits, that is no guarantee that you will receive them, because stockholders only receive profits when they are paid out as dividends. So you know a typical scenario is a company will make a certain amount of net income or have a certain amount of cash flow. The CEO will look at that and say, “well let’s look at our cash and we will split it up. We will put some of it in the bank. We will pour some of it back into the company to invest in future growth, and then a portion of it we’ll pay out as dividends.” That dividend payment then flows back to the shareholders and depending on what percentage you own, that is the percentage you get of that dividend payment. So if you own one percent of stock, you’ll get one percent of that overall amount that was paid out as dividends. So this allows you to participate in the upside or downside of the company. So if the company makes a lot of money, they will have a larger dividend payment. You will get more money as opposed to bonds where it is a set payment.

The other reason stocks are riskier than bonds is bankruptcy. When a company goes bankrupt, bondholders get priority over stockholders, because bondholders have this set agreement. They are going to be paid a set amount and that agreement has to be fulfilled before stockholders get anything.

So those are the two reasons why stocks are riskier than bonds. The reason why all this is important is for managing investment portfolios. Because what you do when you manage an investment portfolio is usually you have this overall portfolio and you have a number of stocks and a number of bonds. What you are trying to do is manage the risk of this portfolio. You want the portfolio to have a certain level of risk. So depending on that level, you can adjust the percentage of stocks and bonds. If you want a riskier portfolio, you can hold more stocks. If you want a less risky portfolio, you can hold more bonds.

There is one other thing I want to touch on and that is tax implications. I always encourage all investors to consider the tax implications of their investments because they can be pretty significant. For instance, if you sold the stock and you made an eight percent gain, you need to not only understand that eight percent gain, but what is going to happen after you take taxes out at the end of the year. With that eight percent gain, it’s probably going to be less. Tax laws change every year. They are going to be different for individuals, corporations, partnerships, and income level, so you really need to talk to your tax professional. But again, I encourage every investor to think about the tax implications of their investment decisions. I will give you a specific example for individuals. Right now, there is a different tax rate for short-term capital gains versus long-term capital gains. This could impact your decision on your time horizons of your investments and the government does this because they want to encourage long-term investment. It’s just an example of understanding your tax strategy when it comes to investments. So to recap, we talked about the basics of stocks and bonds. I gave a description of each, talked about the differences, and then we covered some tax implications.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.