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Chapter 3: Investment Classes

There are three basic types of investment classes.

Stocks
A share of stock represents a percentage of ownership in a corporation. In other words, if a company is divided into a million shares and you buy one share, you would own one millionth of the company. You can make money from receiving dividend payments (a payout to stockholders from the company’s earnings) and/or selling the stock for more than you bought it for.

Most stocks are common stocks. Having common stocks typically allows you to vote for the board of directors, which is responsible for managing the company. With common stocks, the dividend payments are not fixed, and the company is not required to pay them. The other type of stock is preferred. With preferred stocks, you have no voting rights, but regular dividend payments are usually guaranteed (although the amount may be less than what the common stockholders are paid).

Stocks are often classified as one of the following:

  • Blue-chip: Stocks issued by large companies with a solid financial history.

  • Growth: Stocks issued by companies that exhibit strong sales and earnings growth. The companies typically direct earnings back into themselves instead of paying dividends.

  • Income: Stocks issued by companies that generally pay high dividends and experience little growth.

  • Speculative: Stocks issued by companies that do not have a solid financial history. These stocks carry more variability and risk than other stocks.

  • Cyclical: Stocks issued by companies whose earnings mirror movements in the economy.

  • Defensive: Stocks issued by companies that are not significantly affected by changes in the economy.

Historically, over the long term, stocks have provided the highest return. However, there are no guarantees – one day your stock may be worth more than what you paid for it, the next, less. The price of a stock is typically influenced by the performance of the company and general economic conditions, but it can also be influenced by investors’ expectations and emotions, which are not always rational.


Bonds
While stocks are an ownership investment, bonds are a lending investment. You give the bond issuer money, and, in most cases, they pay you interest in return, just like you pay interest to a creditor. Generally you receive the principal (called the par value) at maturity of the bond and interest periodically while you are holding the bond. You make money both from interest payments and purchasing the bond at less than its par value (although bonds sometimes trade at or higher than their par value).

Zero coupon bonds, unlike other bonds, pay no interest but are typically sold at a deep discount. They can be any of the types of bonds listed below and are usually long-term, with a maturity date of ten-plus years.

Types of bonds include:

  • Corporate: Bonds that are issued by non-government companies. Corporate bonds can vary considerably in length, yield, and risk.

  • Municipal: Bonds offered by the state or local government. In general, the interest received on municipal bonds is exempt from federal income tax, as well as state tax if you live in the state you purchased the bond from.

  • Federal: Bonds issued by the federal government. The biggest issuer of federal bonds is the U.S. Department of the Treasury. Electronic Series EE and I bonds are sold at face value and can be purchased for as little as $25. EE bonds pay a fixed-rate of interest, while I bonds come with a variable rate. The interest earned is exempt from state tax. It is also exempt from federal tax if used to pay for qualified higher-education expenses. Treasury bonds can be purchased directly from the government at www.treasurydirect.gov.

Bonds are usually safer than stocks since the bond issuer has a legal obligation to pay them, and as a result, the return is usually lower. However, they are not completely risk-free, as the issuer may choose to breach their obligation or be able to have it discharged through bankruptcy. Also, if you sell a bond before the maturity date, there is a risk you won’t be able to get as much for it as you bought it for.


Cash Equivalents

Cash equivalents are assets that can be readily converted into cash. They tend to be low-risk, with little or no danger that you will lose the money you deposit. Because they are safe, cash equivalents provide a low return, which may not even keep up with inflation. There are many types of cash equivalents:

  • Savings and checking accounts: With savings and checking accounts, you deposit money in a financial institution and receive interest or dividends in return. You can withdraw your money at any time. The interest rate is usually low or may even be non-existent for some checking accounts. Savings and checking accounts are insured, meaning you will still be able to access your money in the unlikely event your financial institution goes out of business.

  • Certificates of deposit (CDs): With CDs, you also deposit your money in a financial institution, but you are required to leave it there for the term of the CD. If you withdraw early, you will have to pay an early withdrawal penalty in most cases. CDs are insured and generally have a higher interest rate than savings or checking accounts.

  • Money market deposit accounts: Money market deposit accounts are similar to savings accounts, but the interest rate is typically variable (and higher as well). They are insured and may come with limited check writing privileges.

  • U.S. Treasury bills: Treasury bills are short-term debt obligations of the U.S. government.
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