Business of Investing - 2
By Saghir Aslam
Irvine , CA
(The following information is provided solely to educate the Muslim community about investing and financial planning. It is hoped that the ummah will benefit from this effort through greater financial empowerment, enabling the community to live in security and dignity and fulfill their religious and moral obligations towards charitable activities)
Risk and Reward: Common Stocks
Common stocks are equity securities. That is, they represent ownership in the issuing corporation. As the assets and liabilities of the corporation fluctuate, the stockholders' equity fluctuates, and so does the book value (balance-sheet value or assets minus liabilities) of your shares. Stock prices can also fluctuate with investors' changing perceptions of the prospects for the company.
From the company's earnings (profits), the board of directors determines what portion will be distributed to stockholders as dividends and what portion will be retained to enhance book value or reinvest in the business. Thus stocks can offer two components of return: dividends and the change in the stock's price.
Neither the stock's future price nor the payment (or amount) of future dividends is guaranteed. If the company fails, its creditors (bondholders) have the first or senior claim on its assets. Common stockholders, as the owners of the company, are paid last.
In return for assuming greater risk, a stockholder has the opportunity for potentially greater reward than holders of some other types of investments. If the company is successful in increasing profits over the years, the stockholder should benefit. Historically, over the long term, stocks have generally outperformed bonds. In exchange for less risk, the bondholder generally accepts the potential for less reward.
In considering a stock investment, think about the following questions:
How is the company that issued the stock doing? Does it have a record of long-term earnings growth? Are the senior managers responsible for its success still in place? Does it have a leading position in its industry? Is it threatened by strong competition or a tough regulatory environment?
How will the company's products and services likely fare over the term of this investment?
Risk and Reward: Bonds
Bonds are debt securities -- the bondholder is a creditor to the issuing entity. A bond acknowledges that you have made a loan of the face value to the issuer, and represents the issuer's agreement to pay you a specified rate of interest over a specified period (hence the term "fixed-income investment"), after which the face value will be repaid to you.
Whereas stocks are ordinarily chosen for their growth potential, bonds are ordinarily chosen for potential fixed-income and capital preservation. This doesn't mean that bonds are without risk, however. When considering bond investments, think about each of the following types of risk:
Credit risk/quality. If the issuer is unable to pay interest and principal when due, the bond is in default. The smaller the chance that the issuer will go into default, the higher the bond's quality rating. Thus a bond rated AAA offers a higher degree of safety -- but it will probably also yield lower interest -- than a bond rated A.
Maturity risk. Some bonds have call provisions. This means the issuer can call (repurchase) the bond from you at a specified price after a stated amount of time. If the issuer chooses to call the bonds, it's usually because prevailing interest rates have fallen since the bond was issued. The call provision allows the issuer to pay you off and re-borrow the face value at a lower interest rate. This leaves you with an unhappy choice between re-lending it at the lower rate or trying to find a better rate elsewhere. To compensate investors for this risk, bonds with call provisions ordinarily offer higher interest rates than bonds that can’t be called.
Liquidity risk. This is the risk that you won't be able to find a buyer should you want to sell your bonds before maturity. For example, a bond from a fairly obscure issuer will not be as liquid -- as easy to sell -- as a U.S. Treasury bond; a bond with complex features will not be as liquid as a simpler bond. Other things being equal, less liquid bonds should offer higher yields to compensate the investor for the added risk.
Interest-rate risk. If you invest long-term and interest rates rise, you may have missed the chance to invest the money at the new higher rates. If you try to sell your bond before maturity in order to reposition the money, you may find that the bond's principal value has fallen (to bring its effective return in line with new bond issues). Similarly, if you invest short-term and interest rates fall, you've missed the chance to invest the money long-term at the old higher rates. Since the long-term investor bears interest-rate risk over a longer period, long-term bonds ordinarily yield more than short-term bonds.
Reinvestment risk. The yield-to-maturity calculation assumes reinvestment of semi-annual income at the stated or coupon rate. A zero-coupon bond is exempt from reinvestment risk, because it is structured to compound at the stated rate of return. (More on zero-coupon bonds below.) On the other hand, a conventional bond with a high rate involves greater risk of not being able to invest the interest payments at that same high rate of return.
Yields on municipal bonds issued by government entities are lower than those for taxable bonds, because the interest on municipals is generally free of federal income tax (and often free of income tax in the state where they are issued). Capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT).
In dealing with bonds, keep three general axioms clearly in mind:
As yields rise, dollar prices ( market values of bonds sold before maturity) decline; as yields fall, dollar prices rise.
For equal changes in yields, prices on longer-term bonds change more than prices on shorter-term bonds.
For equal changes in yields, discounted bonds (bonds purchased at less than face value) undergo a larger percentage change in dollar price than par bonds (bonds bought at face value) or premium bonds (bonds bought at more than face value).
Zero-coupon bonds or "zeros" represent U.S. Treasury obligations. They work much like U.S. Savings Bonds: they are sold at a deep discount and compound at a stated rate until they mature at full face value. Since they do not pay current income, their market value fluctuates with interest rates even more widely than the market value of conventional (coupon) bonds. Thus a drop in interest rates may produce a quick rise in the market value of a long-term zero, offering the potential of a capital gain. However, this upside has a downside: if you take the quick gain, the interest rates at which you can reinvest are lower.
It's also important to note that the assumed growth of zeros is taxable each year, even though you don't receive it until maturity. As with nearly all fixed-income investments, if you sell the zero before it matures, it may be worth more or less than your initial cost. (Continued next week)
(Saghir A. Aslam only explains strategies and formulas that he has been using. He is merely providing information, and NO ADVICE is given. Mr. Aslam does not endorse or recommend any broker, brokerage firm, or any investment at all, or does he suggest that anyone will earn a profit when or if they purchase stocks, bonds or any other investments. All stocks or investment vehicles mentioned are for illustrative purposes only. Mr. Aslam is not an attorney, accountant, real estate broker, stockbroker, investment advisor, or certified financial planner. Mr. Aslam does not have anything for sale.)