Investors often turn to the stock and bond markets when investing their money. Each market offers opportunities and risks for the individual investor. In this lesson, we'll explore the nature of these investments.
Publicly Traded Stocks
Meet Charles. He's an investor who is always looking for good deals. He invests a great deal of his savings in the securities markets, which are markets where stocks and bonds are bought and sold. Stocks and bonds are collectively known as securities. Stocks, also called equities or shares, are ownership interests in a company.
You can remember what a stock share is by thinking of owning a share of a company. If Charles buys a share of Apple, he owns a piece of it. He even has a right to vote on company matters at the annual shareholder meeting.
Most investors invest in publicly-traded securities, which are securities that are listed and traded on a securities exchange. A securities exchange is the marketplace where securities are traded that is maintained by some formal organization or group. Securities exchanges are operated all over the world. Some well-known exchanges include the New York Stock Exchange, the NASDAQ, the London Exchange, the Tokyo Exchange and the Shanghai Exchange.
In the United States, companies that offer their securities for sale to the public must provide a prospectus, which discloses certain information required by the Securities and Exchange Commission (SEC). Smart investors, like Charles, will carefully review the company's prospectus to find out if the investment makes sense. A prospectus includes information such as the company's business objectives, what it does, information about directors and officers, financial statements, foreseeable risks and other important information.
Most investors will utilize a securities broker to facilitate the purchase and sale of securities. Securities brokers are professionals that must pass certain licensing exams and register with the Securities and Exchange Commission. A broker is also subject to the rules and regulations of each exchange with which he conducts business.
Publicly Traded Bonds
A bond, sometimes called a debenture, is a debt instrument issued by a company or government entity to raise money. If an investor, like Charles, buys a bond, the investor is not buying a part of the company, but rather providing financing to the bond issuer. A bondholder is a creditor of the issuer. As you might expect, the biggest issuer of bonds in the United States is the federal government. Cities, states and other local governments will issue bonds, which are generally referred to as municipal bonds, which sometimes are exempt from taxes.
Bonds are often a safer investment because the company or government has an obligation to pay. Creditors get paid before shareholders. The risk of investment is based upon the creditworthiness of the entity issuing the bonds. The safest bonds available are probably U.S. Treasury Bonds. The only way an investor will lose its money with a U.S. Treasury Bond is if the United States defaults on its debt, which is very unlikely to happen. Corporate bonds are riskier but still safer than a stock issued by the same company.
Of course, since the risk is less with bonds, the return is much lower. You'll probably never get rich investing in bonds. Nevertheless, smart investors, like Charles, will often have some bonds in his portfolio to diversify and offset some of the risk of his other investments.
Primary and Secondary Markets
Charles is a pretty savvy investor, and he looks for opportunities in both the primary and secondary securities market. When a company first 'goes public' and offers stock for sale or first issues bonds, the securities are offered on the primary market.
The secondary market, on the other hand, is the place where investors go to trade stocks or bonds that have already been offered and sold on the primary market. You can remember the difference by remembering that securities sold on the primary market are sold for the first time because primary means first. You can remember the nature of the secondary market by remembering that secondhand stocks (used) are sold on the secondary market.
Private Placement of Securities
Charles has a good job and has amassed a significant net worth over the years. He actually meets the securities law criteria for an accredited investor. In order to qualify as an accredited investor, an investor must meet certain financial criteria regarding income or net worth. Accredited investors are considered financially sophisticated and are able to invest in more risky investments that don't have some of the protections provided by a publicly traded stock registered with the SEC.
Since he's an accredited investor, Charles has the chance to participate in some investments not usually available to the general public, known as private placements. A private placement is the sale of stocks or bonds directly to a specific group of investors. Private placements are not open to the general public and are not registered with the SEC.
Investors do receive some disclosure, primarily through a disclosure document called a private placement memorandum. Companies making private placements do have to make notice filings with the SEC, called Form D filings, and filings with each state's security agency, referred to as blue sky filings, in each state where investors are solicited.
Let's look at an example of a private placement. Charles is currently considering investing in a new tech company. The company is offering investors preferred stock with an attractive dividend. Preferred stock is a class of stock that doesn't have voting rights but does give its holders a specific dividend that must be paid before dividends are paid to holders of common stock.
Additionally, holders of preferred stock are paid before holders of common stock if the company is liquidated. Of course, the company is not just being generous; it needs to offer a lucrative deal to attract investors because there's a good chance that the company will fail. Charles may make a lot of money or lose his entire investment.
Let's review what we've learned. Many investors invest in securities, which include stocks and bonds. A share of stock is an ownership interest in a company, while a bond is a debt instrument issued by a company or government entity.
Stocks and bonds can be purchased on a primary market, where they are first offered to the public for sale, or on the secondary market, where previously purchased securities are traded. Stocks and bonds are often purchased with the help of a licensed securities broker.
Some investors are accredited investors, which are investors with sufficient wealth to bear the risk of the loss of their entire investment. Accredited investors have an opportunity to take part in private placement of stocks or bonds that are not registered with the SEC or offered to the general public. While the reward is potentially high with private placements, investors have a real chance of losing their entire investment because the investments are often risky, such as investing in new startups with no track record of success.
Once you've finished with this lesson, you will have the ability to:
- Define stocks, bonds and securities
- Differentiate between the primary and secondary markets
- Explain what an accredited investor is
- Describe some advantages and risks of being an accredited investor