Written by It happened again. You’re standing around the water cooler when your colleague Bob starts discussing the financial markets and how it’s affecting his retirement accounts. You gulp down your water, nod your head in agreement and sneak back to your desk.
The stock market is mentioned so frequently in social situations that it’s becoming harder to avoid. When did the subject beat out weather or cinema for the best conversation starter? Instead of walking away or, better yet, repeating verbatim what you heard on the morning news, let’s start by understanding some of the basics.
What are stocks and bonds?
Stocks
The most popular definition of a stock is, “a share in the ownership of a company.” In other words, a stock represents a claim on the company’s earnings, paid in the form of dividends. The more stock you acquire, the higher your stake in the company, but it doesn’t mean you get ownership rights, as some people may think. They do, however, give you the right to vote in shareholder meetings, receive dividends (company profits) and sell your shares as you please.
Time for the fun part! Think of a large apartment complex, representing a company, and each individual apartment represents shares in the company. The larger the apartment, the more shares it represents. Although you can purchase an apartment, this does not make you the owner of the building. It does, however, give you the ability to vote on decisions that affect the complex or elect board members into power who can make the decisions on behalf of the residents. This is pretty much the definition of a co-op, which is a prevalent form of home ownership on the East Coast. To learn more, read Housing Cooperatives: A Unique Type of Home Ownership.
So, how the hell do I make money by purchasing a stock? Let’s go back to the apartment complex example …
You notice a sign announcing a soon-to-be-constructed complex. The realtor informs you they will have state-of-the-art appliances and a beautiful rooftop pool. If you purchase before construction, you could be able to sell your apartment in the future for much higher than the purchase price. This is known as investing. When you invest, your money is intended to be put to work to increase value.
The realtor shows you another building that is run down, but informs you that this is an up-and-coming area. She says there are rumors of a large community park being built nearby. If you purchase an apartment within the building, the value of the property may go up as the neighborhood improves. This is known as speculation. Speculators buy something with the hope that they can soon sell it at a higher price, but don’t concern themselves with why or how the price should go up.
There is one crucial part of the equation that our example leaves out and that’s dividends. CASH MONEY BABY! — Just kidding. When companies make profits, they can choose to claim them as earnings or pay them out as dividends to shareholders. Dividends can be paid out either in cash or additional shares of stocks (or in the case of our example, square footage).
Bonds
Bonds are a form of debt or a loan where you’re the lender. If a government or municipality (e.g., the United States or the State of Texas) would like to build a bridge or a highway, they may choose to issue a bond. When you purchase a bond, you are actually lending money to the government with the understanding that they will pay you back in full at the end of the term, and pay regular interest.
The price of bonds changes inversely, according to interest rates in the economy. What does that even mean!? I know bonds sounded simple up until this point, but of course, they have to throw us a curve ball. As new bonds are issued and are paying higher interest rates, it causes the price of already issued bonds to go down. And inversely, as interest rates fall, the price of bonds go up.
Analogy time! You purchase a lemon tree for $100 that will grow 1 lemon per month for 12 months. The going rate for one lemon is $0.50. After a week, you decide you don’t like lemons and want to sell the tree. Unfortunately, they are now selling the exact same lemon tree for the same price. The only difference is that these trees grow 2 lemons per month. For you to sell your tree, you need to lower the cost to account for that dang extra lemon. You reduce the price of your tree by $6 (12 months x $0.50) and sell it for $94.
This is how the inverse relationship between bonds and interest rates works. Why would anyone want to purchase a bond from you if they can get the exact same bond growing more lemons (or interest)? Of course, if you hold your bond to maturity, you will still get your principal back in full.
Feeling confident enough to add to the conversation? There may be a lot more to learn before you start to school Bob at the water cooler, but this is an excellent place to start. Stocks and bonds are essential to understanding the financial markets. What other questions do you have? Leave me a comment below.
Michael D. Gould 