Stocks and Mutual Funds

Stocks are the securities with which many people are most familiar. (The term securities means different types of investment instruments, including stocks, bonds, mutual funds, options, and municipal bonds.) Mutual funds may include stocks or other types of securities. Mutual funds are purchased as shares, but they are shares in a large pool of securities managed by a professional investor. Purchasing stock outright and buying shares in a mutual fund are two common methods of investing. This publication gives an overview of both.

Stocks

The ups and downs of the stock market make the national news nightly, and most people know someone who has made—or lost—money in the stock market. This is not surprising because individual investors have traditionally been the major owners of common stock.

In the New York Stock Exchange, however, most trading activity is done by institutional investors who have large portfolios to invest, such as managers of pension funds, investment companies, life insurance companies, and bank trust departments. Individual investors may account for more activity in other markets, such as the American Stock Exchange and the over-the-counter market.

Most experts agree that over the long run, stocks have performed better than most other financial assets. Tables from The Price Waterhouse Book of Personal Financial Planning indicate that small company stocks gave an average return to investors of 12.6 percent over the 60-year period from 1926 to 1985, and common stocks averaged 9.8 percent over the same period. Compare these figures to the 4.8 percent average for long-term corporate bonds and 3.4 percent for U.S. Treasury bills (T-bills). Keep in mind that these figures show returns for the long run only—during a shorter term the return would have fluctuated greatly. Before you consider investing in the stock market, you should understand the basics of stocks and of the market.

The Basics

The two basic types of stock are preferred and common stock. Preferred stock is so named because shareholders receive preferential treatment in certain respects: they are paid dividends before common stockholders are paid anything, and if the corporation liquidates they are also paid off (after bondholders). Preferred stock usually has a fixed dividend rate, which means that preferred stockholders are protected in times of low company profit. On the other hand, in peak performance times preferred stockholders may receive less than common stockholders. Also, preferred stockholders do not usually have voting rights in the company.

Common stock, however, is what most stockholders buy. With common stock, the potential return is not limited by a fixed rate. Also, common stockholders have voting rights in the company; the weight of that vote is based on number of shares owned. However, a higher potential return on common stock also means a higher risk of little or no return. (See Extension publication HE-625 in this series, Savings and Investments, for an explanation of the trade-off between risk and return.)

Both kinds of stockholders have limited liability for the debts of the corporation up to the amount of their investment.

The book value of a corporation is the value of the stockholders’ equity, or ownership interest, as shown on the books—that is, the balance sheet. (Balance sheets are discussed below.) The book value per share is a measure of the company’s net assets divided by the number of shares of common stock that are outstanding.

Dividends are cash payments made by the corporation to its stockholders. They are determined by the board of directors and can range from zero to any amount the company can afford to pay. As a stockholder, you have no guarantee that you will receive dividends.

A stock dividend is a payment by the corporation in shares of stock instead of cash. A stock split is the issuance of a larger number of shares in proportion to the number of shares outstanding. For example, a corporation might issue a 2 for 1 split, which means two shares of stock will be issued for each one share outstanding. Other things being equal, a stock dividend or stock split usually does not represent additional value to the investor with respect to his or her proportional ownership of the corporation. It simply means that each share of stock now costs less and is more attractive to buyers.

Stockholders with voting rights may attend the annual meeting of a corporation and vote on major issues such as electing directors. Most stockholders vote by proxy, which means that the stockholder gives someone else, usually the management of the corporation, authority to vote the stockholder’s shares.

Types of Stocks

Stocks are often classified by financial analysts into four separate categories. The first is income stocks, which are stocks that produce steady income in the form of dividends. These stocks appeal to the investor who needs current income. Income stocks are usually the least risky, so they fit into the portfolio of the more conservative investor.

Second are growth-and-income stocks. These are stocks that produce perhaps more modest dividends, but that also have a reasonable expectation of growth, or appreciation. These are relatively safe investments and appeal to the investor with a low tolerance for risk. An example of this type is blue chip stocks, which are stocks of companies that are well known and have strong records of growth, profit, and dividend payments.

Next are growth stocks, which are stocks of faster-growing companies. These stocks are more volatile in price than the stocks in the first two categories and they are more risky. These companies usually do not pay dividends because they reinvest their earnings.

The fourth category is aggressive growth stocks. These also are stocks of fast-growing companies that pay few or no dividends. The stock prices are more volatile than the growth stocks described above, and they are considered high-risk stocks. Although the chances for loss of principal are high, so are the chances of success.

The Stock Market

The market for buying and selling stocks is primarily a secondary market. This means that most stocks are traded at resale among other investors. Often stocks are bought and sold through brokers, who work with buyers and sellers as intermediaries or go-betweens. Brokers receive commissions for their work.

Stocks are traded on the New York Stock Exchange, the American Stock Exchange, regional exchanges, and the over-the-counter market.

The New York Stock Exchange (NYSE) is the oldest (founded in 1792) and most prominent secondary market in the United States. Approximately 2,100 stocks, mostly of large firms, are listed on the NYSE. The New York Stock Exchange is a not-for-profit corporation whose members are primarily partners or directors of stockbrokerage firms. Most members of the NYSE act as brokers for customers or for their own accounts. Others are specialists who buy and sell shares of an assigned stock in such a way as to make sure the market in the securities of their assigned companies remains orderly.

The American Stock Exchange (AMEX) is the only other national organized exchange. Until 1921, the AMEX was known as the Curb Exchange and is sometimes still referred to as the Curb. The organization of the AMEX is similar to that of the NYSE except that it is smaller and fewer companies are listed there. Usually, the stocks and bonds that are traded on this exchange belong to companies smaller than those found on the New York Stock Exchange.

There are several regional exchanges located throughout the country, such as the Midwest Stock Exchange, the Boston Stock Exchange, and the Cincinnati Stock Exchange. The listing requirements for these exchanges are much more lenient than the New York Stock Exchange. Usually, regional exchanges list small companies that have limited geographic interest, but most of the securities traded on these exchanges are also traded on the NYSE or the AMEX.

Another market for stocks is the over-the-counter market (OTC). Unlike the markets described above, the over-the-counter market is not a central place to trade stocks. Rather, it is a way of doing business. Dealers in stock make transactions through computerized communications systems. The OTC market handles stocks that are not traded or listed on an organized exchange such as the NYSE or the AMEX. While over-the-counter stocks have traditionally been those of smaller companies, some larger companies have recently decided to remain with over-the-counter trading. These companies sometimes find trading in this market more advantageous. The OTC market is becoming increasingly important in the arena of market trading alternatives.

The individuals and organizations engaged in buying and selling securities are self-regulating organizations operating with the oversight of the Securities and Exchange Commission. The group that oversees OTC practices is the National Association of Securities Dealers (NASD), which is a self-regulating body of brokers and dealers. The NASD introduced a computerized communications network called NASDAQ, which stands for National Association of Securities Dealers Automated Quotations System. This system offers current price quotations for stocks traded over the counter as well as quotations for many stocks listed in the NYSE and AMEX. NASDAQ quotes are published in the financial pages of most newspapers.

Finally, there are other markets that are used primarily by large institutional investors and wealthy individuals. These markets offer certain services that are not offered by the larger exchanges.

Risks and Returns on Common Stocks

It is relatively easy to mathematically determine your return for any particular period on stock that you own. The return on your stock can be separated into two parts, dividends and capital gains or losses. The capital gain or loss is the difference between the amount at which you purchased the stock and the price at which you could sell it. Although many investors are attracted to stocks by the potential capital gain, many stocks derive a major portion of their total return from the dividends they yield.

Determining the holding period yield (HPY) will help you measure the return that you have received over a certain period of time. The formula for holding period yield is as follows:

Holding Period Yield = Dividends + Price Change divided by Purchase Price

Suppose, for example, you bought fifty shares of stock at $100 per share 1 year ago. You have received a total of $0.95 per share over this quarter from dividends, and the price of the stock has risen to $110 per share. Your holding period yield would be: