Stocks and Bonds

The ABCs of investing in stocks and bonds.

When you buy stock, you are buying a share of ownership in the corporation that issued it. The corporation issues the stock as a way to help finance its operations. If the company does well, the price of the stock goes up. When the company doesn't do well, the price of the stock goes down.

Shares of stock in most large companies are publicly traded, either on a stock exchange, such as the New York Stock Exchange or the American Stock Exchange, or in what's known as the "over-the-counter" market, where stocks are bought and sold not by making trades on the exchange floor but by telephone calls made from one brokerage to another. Some small companies don't offer their shares for sale to the general public, but raise money by selling shares to the friends and family members of the company's founder. This kind of corporation is known as a closed corporation. One advantage to a closed corporation is that the sale of its stock to friends and family is not as strictly regulated as when shares are offered to the public at large. When a company offers its stock to anyone who wants to buy it, it must comply with a variety of state and federal laws before it can sell a single share. The company must issue a prospectus, listing all of the potential risks involved in its operations as well as its profit potential.

If the shares are to be offered in more than one state, this prospectus must be reviewed by the federal Securities and Exchange Commission, or SEC, which can require the company to provide additional warnings if it feels the prospectus is overly optimistic about the company's chances of success. Even after the prospectus is approved by the SEC, however, that doesn't mean the SEC endorses the stock offering. All it means is that the prospectus has made the disclosures required under federal law. Similar requirements are imposed by state laws when the stock is being offered for sale to the public in only a single state.

Stocks fall into one of two categories. Common stock, is, as its name suggests, the type of stock most commonly issued by a corporation. If the company profits, its management may decide to pay out what's known as a dividend, a share of the profits. Or it may decide not to pay dividends, and instead reinvest the profits in expanding the business. When you own common stock, you have no specific right to receive dividends unless and until the board of directors votes to issue them. And even if you are receiving dividends on shares of common stock, the board can decide to terminate them if it feels the money you are receiving could be put to better use elsewhere.

With preferred stock, you are usually promised a specified dividend which you receive quarterly. On the down side, however, the price of preferred stocks usually doesn't rise as quickly as the price of common stock in the same company. If the company suffers hard times you may find your dividend payment suspended, although you have a "dividend preference" which means you get to catch up on unpaid dividends when (and if) times improve before the company can make dividend payments to the owners of common stock. And most preferred stocks can be "called" by the company, which means they can buy them back from you, or exchange them for shares of common stock if the company feels dividend payments are too high.

Although in most cases you must buy shares of publicly traded stock through a stock brokerage firm, there are some companies that will help you avoid a broker's commission charges on additional purchases of stock. These companies offer what are known as DRIPs, or Dividend Reinvestment Plans. After you make your initial purchase, any dividends you earn on them are automatically reinvested in new shares for your account, purchased at the current market value. Some DRIPs even let you invest cash to buy additional shares. A word of warning about DRIPs -- it usually takes much longer to buy or sell stocks through one of these plans than through a broker, so if the timing of your transactions is important, these plans may not be for you. To find out if a company you're interested in has a DRIP, write to it at its corporate offices, directing your inquiry to the Investor Relations Department.

Unlike what happens when you buy a stock, when you buy a bond you don't get any ownership of the company that issued it. Instead, you become one of the company's creditors. In essence, a bond is simply a loan agreement under which the company agrees to pay you a specified rate of interest for a specified period of time until the bond matures. In some cases, bonds, like preferred stocks, may also be called or paid off before they mature. This is most likely to happen when interest rates fall and its cheaper for the company to pay off old high interest dates by borrowing at a lower rate in the current market.

Corporations aren't the only entities that issue bonds. The federal, state, and local governments also issue bonds as a way to raise money, and some quasi-governmental bodies, like water and sewer districts may also issue them to pay for expansion and improvements in the services they provide. Bonds issued by the federal government are known as treasury bonds; those issued by state and local governments and agencies are known as municipal bonds.

Interest you earn on a treasury bond is taxed by the federal government, but not by state or local governments. Interest you earn on municipal bonds usually isn't taxed by the federal government, or by the state and local tax departments in the states that issue them. Interest on corporate bonds is taxed by everybody.

Although you can buy individual bonds, you may also invest in what's known as a bond mutual fund. These funds diversify your investment by buying the bonds of a variety of bond issuers, which minimizes the risk you face if one or more of them goes broke. Most financial experts suggest that small investors use one of these funds to invest in the corporate or municipal bond market, but they suggest that you invest directly in treasury bonds, since the only way these bonds can fail is if the U.S. government decides to stop paying its bills, a highly unlikely scenario.

Another way that the federal government raises money is through the sale of U.S. Savings bonds. These bonds can be especially attractive to those who want a safe investment at a relatively low cost. You can buy up to $15,000 per year in Series EE savings bonds, and for as little as $25. If you hold the bond for at least five years, you get a guaranteed rate of return which is usually a little higher than what you would get on a CD. (To obtain information about current interest rates, which are adjusted periodically, call 1-800-US-BONDS toll-free.)

You can cash savings bonds after you've held them for six months without incurring any penalty. You don't have to pay a commission to buy a savings bond, there's no state or local income tax imposed on the interest they earn, and federal income taxes are deferred until you redeem the bond (cash it in). And if you use them to finance a child's college education, you may not have to pay any federal income tax at all if your family income falls below a certain level.