Investment Vehicles

In a capitalist society, corporations provide extensive opportunities to invest. Companies fund startup, and expansion by raising capital through bonds or through the sale of equity. Bonds are the corporate version of a personal loan. In return for the use of the money, an organization agrees to pay the investor a regular interest payment, called the coupon payment, plus return the original amount of money after a certain period of time.

The risk lies in the possibility that the corporation will find itself unable to make the coupon payments and/or pay back the money due to financial difficulties. The level of coupon payments depends on the perceived likelihood of financial difficulties. Thus, corporate bonds are rated according to their creditworthiness. Just like credit cards for consumers, a business with lower a credit rating must compensate investors with a larger coupon payment. The table to the left provides the credit rating key for S&P ratings.

The sale of equity, or stock, involves the sale of a share of the company to investors. Stockholder's return, unlike bondholder's, is directly linked to how much money the business earns. Whereas a bondholder receives only a fixed amount regardless of the level of profits, shareholders earn more as profits increase. Shareholder return comes in two forms. First, the company can pay out the profits directly, in the form of dividends. Alternatively, the company can reinvest the profits in the company, in an effort to grow future profits. In the latter case, the shareholder is rewarded with a higher stock price, resulting from the promise of higher future dividends. The primary risk facing a stockholder is the possibility of lower future dividends (i.e. lower earnings) than anticipated. Another clear difference between these two groups of investors is the outcome of a bankruptcy. Investors are owners, and thus are liable for the debt of the company. However, this liability is limited to their initial investment. Thus, bankruptcy usually results in the cancellation of shareholder equity (i.e. they rip up your certificates!). On the other hand bondholders, as creditors, are placed ahead of shareholders in the distribution of assets, and so usually receive some compensation. A final difference is in the running of the corporation. Shareholders have voting rights proportional to the amount of shares they hold. This gives them influence over the selection of the board of directors, and other important matters, such as mergers. Bondholders have no such power.

Corporations are not alone in their need for financing; governments also play a key role in the securities market. While you cannot buy equity in the US government, as you already own a piece, you can loan it money. At the federal level, the primary issuer of debt is the US treasury. Unlike corporations, the possibility of the government going bankrupt is nonexistent. For this reason short-term treasury notes are considered risk free. Longer-term treasury bonds, which go up to thirty years, are considered only slightly risky because of the possibility of interest rates going up while locked into a long-term bond (i.e. market risk). At the local level, municipal governments can also issue bonds. Most municipal bonds are tax exempt from federal taxes, and as such pay less than government bonds. The investor should take care to realize the different types of municipal bonds. One type, general obligation bonds, are backed by the full taxing power of the institution, whether it is the state, city, or county. Other bonds are directly linked to some specific project. New airports are often funded by these bonds, called revenue bonds. Obviously, the risk involved in these bonds exceeds that presented by a general obligation bond.

For the small investor, with limited capital, finding a suitable investment vehicle can be tough. What do you invest in if you only have fifty dollars a month? Well bonds usually come in increments of $5000 or $10000, and fifty dollars might not even buy you one share of stock, not to mention the commissions involved. If you need a risk free investment, certificate of deposits provide returns similar to treasury notes. Offered by banks, the capital invested is backed by the FDIC, just as in a regular savings account. Mutual funds provide another way to invest small amounts money, but with greater flexibility than CDs. Boiling it down, a mutual fund simply pools the money from numerous investors. Established with a set objective, be it investing in stocks or bonds or both, a manager runs the fund. The impressive diversity of mutual funds allows the individual investor to find a fund that suits their objectives and risk tolerance. The disadvantages include a lack of control over which securities the manager chooses, and additional overhead expenses that can eat into profits.

Two other vehicles of investment are also in wide use, real estate and precious metals. For several reasons, neither vehicle provides a suitable alternative for the normal investor. First take a look at real estate. Here the incremental cost far exceeds most investments, even bonds. Building a diversified portfolio of real estate property would require a portfolio in excess of a million dollars. Also, the logistical problem associated with the physical maintenance of property requires time that many investors do not wish to commit. Before we continue lets debug the myth that a personal home can serve as a form of investment. One house does not make a well-diversified portfolio; it would simply be too risky. While the long term value of a house may very well appreciate it simply should not be viewed as an investment, but rather as a rental. When considering the purchase of a house, the buyer should compare the benefits and costs of living in a house compared to renting an apartment or other living space. If the house appreciates, you'll just get a lucky bonus. With this said, vehicles do exist which allow the individual to invest in real estate indirectly. Several bonds and stocks derive their returns by investing in house mortgages. Two examples, GINNIE MAE and FREDDIE MAC present an attractive alternative to direct investment. Next on the chopping block, investing in precious metals proves to be a real dog. Unless you think the year 2000 will cause red lights to malfunction, therby leading a car to crash into a bank, thus destroying the vault and wiping out your cash savings, don't bother. (Sorry about the obsolute reference) A piece of gold has no fundamental way to increase its value, other than inflation. Corporations grow and increase profits, real estate grows in value as a city develops and attracts businesses, while gold just sits there, with no way to increase its economic worth. Thus, the only thing gold will do is cancel out inflation. However, by taking no additional risk the individual investor can get a few extra percentage points through CDs. If you want a nice piece of jewelry for your collection, fine, just keep it as a hobby and not an investment.

In summary, this site will concentrate on stocks and bonds, the fundamental vehicle for the individual investor. All other investment vehicles suitable for individuals, real estate derivatives and mutual funds, are based upon bonds and stocks.

Before you can consider investing, you must understand the market for bonds and stocks, and how the value of each of these vehicles is derived.
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