Lesson 2: Understanding the 3 Main Investment Vehicles

I.                    Stocks

a.       Common Stock – Corporations are a form of business that offer ownership in the company to the general public through the issuance of stock.  A company “goes public” by organizing itself as a corporation (in accordance with the business laws of the country in which it operates) and issuing shares of stock on a stock exchange through an Initial Public Offering (IPO).  The largest stock exchange in the U.S. is the New York Stock Exchange (NYSE) located on Wall Street in New York City.  All of the major U.S. corporations, along with many major foreign corporations, list their stock on the NYSE.  This stock exchange is so famous that it has become synonymous with the words “Wall Street”.  Stock (ownership) in a corporation is purchased through buying shares of the company’s stock through traders on the stock exchange where the company is listed.  The money raised by issuing shares of stock can be used by the corporation to fund its operations or pay its obligations.  Once issued, the price per share of a company’s stock rises and falls based on many things including;  market conditions, number of company shares on the market, competition, public opinion, the company’s financial condition, etc…  Corporations are legal entities that are separate from their owners.  Corporations are owned by their shareholders.  However, corporations can own property, incur debt, sue and be sued separate from the owners.  This unique quality of a corporation to operate independent of the owners (shareholders) protects the owners from damages related to issues such as legal liability and the solvency of the corporation.  If the corporation is found culpable in a legal battle, or is unable to pay its debts or other obligations the shareholders are not held liable.  The only loss the shareholders incur related to legal obligations of the corporation, or if a corporation goes bankrupt or out of business, is the loss of the value of the stock held by the shareholders. 

All of a corporation’s shares that have the same rights are known as “common stock”.  Ownership of common stock provides you with certain rights in relation to the operation of the corporation such as; 

1.       ownership of a nonredeemable security (share of company stock)

2.       the right to offer your nonredeemable security (company stock) for sale at any time and for any price

3.       the right to limited liability (as discussed in the paragraph above)

4.       the right to receive a copy of the company’s annual report

5.       the right to attend shareholder meetings

6.       the right to vote to elect the company’s board of directors, and to vote on other matters that come before the board of directors (the number of votes is equal to the number of shares of common stock owned)

7.       the right to examine some of the company’s financial and other records

8.       the right to receive a share of any dividends declared by the company’s board of directors

9.       the right to share in the assets of the company upon dissolution or liquidation

b.      Preferred Stock – Preferred stock can be thought of as a hybrid between common stock and corporate bonds.  They are like bonds in that the return on the investment is fixed and usually limited.  They are like common stock in that they do not mature (expire) and the holder is an owner not a creditor.  They are also in the middle with regard to access to corporate assets upon dissolution or liquidation.  In general bond holders receive first right to corporate assets upon dissolution or liquidation, preferred stock holders receive second right to the assets and common stock holders receive third right.  Preferred stock holders also receive preferential right to corporate dividends over the common stock holders.  However, they rank behind corporate bonds with respect to dividends because the corporation has a legal requirement to pay interest on bonds whereas there is no such legal requirement to pay dividends to preferred stock holders.  The actual rights of the preferred stock holder are found in the company’s charter.  Preferred stock is issued in many different forms including cumulative¹, participating², redeemable³ and convertible⁴.  Because the return on preferred stock is limited to that declared when the stock is issued the growth possibilities are generally not as good as with common stock.  Also, the return on preferred stock is normally tied to a percentage of the dividend declared on the stock and as such the return could be deferred, or eliminated if the board of directors defers dividends or defaults on the dividend.  Preferred stock holders normally cannot vote in company elections unless the dividends are in default.

II.                  Bonds

a.       A bond is formal evidence of a debt owed.  Bonds are issued by corporations, federal, state and local governments as a means to finance certain activities and/or projects or to fund ongoing operations.  When a corporation or government issues a bond they are offering the holder of the bond a promise to be paid a specific amount of interest at specific intervals and for a specific duration (term or maturity).  When the bond matures (expires or finishes it term) the corporation or government promises to repay the bond holder the amount of money originally paid for the bond (the principle). 

b.      As an investment bonds are fairly easy to understand because generally the maturity (duration), interest rate, and interest payment schedule are published with the bond so it is very clear what you are buying.  However, there are a vast variety of different types of bonds so understanding what type you are buying can get a bit confusing.  For example; bearable bond⁵, callable bond⁶, convertible debenture⁷, discount bond⁸, first mortgage bond⁹, registered bond¹⁰ and serial bond¹¹ are a few of the different types of bonds available on the market. 

c.       In general the interest rate paid on a bond is proportional to the risk associated with the issuer of the bond.  The U.S. Treasury bill (T-bill) is considered the safest and most marketable security in the world and therefore merits the lowest interest rate.  The U.S. Treasury also issues savings bonds, Treasury bonds and Treasury notes that all merit ultra-low interest rates because they are considered to be virtually “risk free” as they are backed by the full faith and security of the U.S. Federal government.  The U.S. Federal government has never defaulted on payment of its bond obligations.  Bonds issued by state and local governments (municipal bonds) are also considered low risk (albeit not zero risk as there have been examples of school districts, cities and even states defaulting on their bonds). The risk associated with corporate bonds varies widely based on the credit rating of the company issuing the bonds.   Federal, municipal and corporate bonds are rated by many domestic and international rating agencies.  The three major U.S. rating agencies are:  Moody’s¹², Standard & Poor’s (S&P)¹³ and Fitch Group¹⁴.  As stated before the U.S. T-bill is considered the safest and most marketable security in the world and as such the U.S. Federal government has historically held the highest possible rating by all three major U.S. rating agencies (Aaa by Moody’s, AAA by S&P and Fitch).  However, on August 5, 2011 the S&P rocked the domestic and international investment markets by downgrading the U.S. Federal government from AAA (outstanding) rating to AA+ (excellent) rating.  Moody’s and Fitch did not downgrade the government but each did issue a negative outlook in 2011 for the government retaining the highest rating.  Fitch has since removed its negative outlook in March of 2014. 

d.      In general the amount of interest a government or corporation must offer in order to attract buyers to their bonds increases as their credit rating decreases.  Bonds with a rating of “BB” by S&P and Fitch, or “Ba” by Moody’s are often referred to as “junk” or “high-yield” bonds as they are considered high risk, speculative or below investment grade and therefore carry much higher interest rates (yields) than bonds from issuers with higher credit ratings.  Bond prices generally fluctuate inversely with market interest rates (i.e. when interest rates rise bond prices fall and when interest rates fall bond prices rise)¹⁵.  Municipal bonds have the added advantage of paying interest that is normally free from federal taxes.

III.                Cash

a.       Savings accounts (passbook accounts), Certificates of Deposit (CDs) and interest bearing checking accounts are the primary examples of “cash” investments.  The interest paid on such “cash” accounts are, in general, lower than the other types of investment vehicles described above and for the past several years have been at near zero (below zero when adjusted for inflation).  However, in terms of security, as long as the money is placed in an institution that is insured then the principle is guaranteed up to the limit of the insurance on the account.  Also, in terms of liquidity, or ease of access to the funds, cash accounts are considered the most liquid investment because funds can be withdrawn at any time, normally without penalty (except in the case of early withdrawal from a CD).  It is always a good idea to have a certain amount of cash on hand to cover emergency needs, but in the current ultra-low interest environment on cash accounts it is advisable to keep cash to a minimum.

IV.                Risk vs return

a.       The primary risk associated with ownership of corporate common stock is the decrease in stock price.  If you must sell your shares and the per share price of the stock is less than when you bought the shares you will suffer a loss on the sale.

b.      In general, the larger the potential return on an investment, the higher the risk.  Below is a table that compares the general risk vs return of the three main investment vehicles discussed in this lesson:

Investment Vehicle	Risk	Return
Stock	High	High
Bond	Low/high (depending on type of bond)	Low/High (depending on type of bond)
Cash	Low	Low

Foot Notes

¹ Past, omitted dividends are paid to preferred shareholders, then to common shareholders.

² The stock holder has the right to the normal preferred dividend rate plus a bonus dividend based on a predetermined condition.

³ The issuer of the stock can buy it back and retire it.

⁴ The stock holder has the option, past a certain date, to convert the shares into a number of common shares.

⁵ A bond on which the owner’s name is not registered with the issuer.

⁶ Also known as a redeemable bond, the issuer can redeem this bond before it reaches maturity. Usually, the bond owner is paid a premium when the bond is called.

⁷ A company-issued loan that the bond holder, or sometimes the issuer, can convert into stock. This allows for a lower interest rate paid by the issuer.

⁸ A bond issued, or currently trading in the secondary market, for less than its par/face value.

⁹ A bond backed by real property or real estate owned by the issuer.

¹⁰ The company records (registers) the bond owner’s name and contact information in order to pay the correct person.

¹¹ Multiple bonds issued at the same time and quoted by their yield that mature at regular intervals until all the bonds have matured.

¹² This corporation provides credit ratings, research, tools, and analysis for transparent and integrated financial markets. It is the parent company of Moody’s Investors Service (credit ratings and research on debt instruments and securities) and Moody’s Analytics (software, advisory services, and research on credit and economic analysis and financial risk management).

¹³ This rating service provides an opinion on the general creditworthiness of an obligor.

¹⁴ This service provides financial information through Fitch Ratings (credit ratings and research), Fitch Solutions (credit market data, analytical tools, and risk services), Fitch Learning (learning and development solutions for the global financial services industry), and Business Monitor International (country risk and industry analysis specializing in emerging and frontier markets).

¹⁵ If interest rates drop (to 5% for example), higher return rates (such as 9%) are more attractive. Therefore, more people buy those bonds, increasing the price until the yield matches the dominant interest rate (5%). If interest rates increase (to 9%), the lower return rates (5%) become less attractive, forcing the bond prices to decrease to attract demand and increase the yield.

Lesson 1: Getting Started

I.                    Understand where your money is currently going

a.       Keep all receipts – Use a filing cabinet, file box, file folder, shoe box or any other appropriate means to file receipts.  Ask for a receipt of every transaction, even if it is a cash transaction, and file all receipts for later use.  All receipts should be checked against your bank/credit card records to ensure they have been recorded correctly (yes, mistakes are still made in recording transactions, even in this “electronic age”) and to also ensure that no unauthorized transactions are occurring.

b.      Avoid using cash – This is one of the little known ways to better track your spending and reduce unnecessary spending.  Most people withdraw cash from a bank in “chunks” of $20, $50, $100 or more and then spend it on miscellaneous items with little or no tracking of what it is spent on.  At the end of the day, week, month or whatever all of their cash has been spent and they have virtually no idea what it was spent on.  Using a check or credit card provides a written or electronic record of the expenditure that is much easier to categorize and track.  Minimizing the use of cash is the first “secret” to good money management.

c.       Record everything you spend money on every day – There are many software packages available as freeware, shareware or for purchase online or in stores that can be used to record your purchases (e.g. Microsoft Money).  It is important to record all purchases, even seemingly small or insignificant ones, to get a full picture of where your money is currently going.  I use an online banking/brokerage account where all of my checks and credit card transactions are recorded and I cross-check all transactions against my receipts to track my spending and to ensure that no unauthorized activity is occurring in my accounts.  If you don’t have software, or don’t want to avail yourself of it, you can always use the “old fashioned” method of writing everything down in a notebook or ledger book.

d.      Categorize your spending – Again, most software for recording expenditures includes a feature for categorizing your spending.  If you are using a notebook or ledger make each page a separate category by writing the category at the top of the page and recording only the expenses for that category on that page.  My online banking/brokerage account allows categorization of expenditures and I use this feature to help understand what I am spending my money on.  It is important that you develop sufficient categories that you have a place to record most of your expenditures.  Having just a few categories can result in a large percentage of your spending going into the “miscellaneous” category which gives you no useful information on where your money went.  Avoid using a “miscellaneous” category.  If you find that many of your expenditures don’t fit easily into one of your existing categories, create another category.  Appendix A contains a list of the categories I use for tracking my expenditures.  The more categories and subcategories you have the more likely it is that you will be able to find a category for each expenditure.  However, there is obviously an upper limit to the number of categories to use because you don’t want every expenditure to be its own category.

II.                  Recognize areas where you can reduce or eliminate spending (i.e. differentiate a “want” from a “need”)

a.       What is the minimum you need to function – At the most basic level there are only four things that every human needs:  air, water, food, and shelter.  Obviously none of us live, or want to live, at that most basic level but keeping that level in mind helps put other “needs” in perspective.  For example, unless you live in a nudist colony most of us “need” some form of clothing, but do we need the latest designer clothing from the high end boutiques?  The answer to that question for most of us is definitely no.  However, for those who design, market, model or sell the high end clothing the answer may be yes.  Each of us is an individual with different circumstances so only you can determine what the minimum you need to function is. 

b.      What spending can you eliminate – The second “secret” to good money management is to review your daily, monthly and annual expenditures, as recorded and categorized in Sections I.c. and I.d. above, with a critical eye to determine which expenses can be reduced and which can be eliminated.  It is important to repeat this critical review of expenses regularly as excessive and/or unneeded expenses have a tendency to creep back into your spending if you don’t constantly weed them out.  I categorize my expenses on a weekly basis and review them for changes on a monthly basis.  I recommend categorizing your expenses at least monthly and reviewing them for changes at least annually.

c.       Allow for “needed” spending changes but avoid “unneeded” spending changes – Throughout our lives there are many “needed” spending changes that occur.  For example as a young adult educational expenses are generally an important “needed” expense to set the person up for success in the future.  Once the person finishes school their educational expenses should decrease dramatically while other expenses like relocating for a job, getting married, buying a house, etc. will increase.  It is important to recognize that our “needed” spending changes with time but keep a critical eye open for the “unneeded” spending that always tends to creep in if we don’t continue to monitor and control our spending.

d.      Set goals for achieving certain purchases (deferred gratification) – The third, and possibly the hardest to follow, “secret” to good money management is deferred gratification.  If you have something you want, but you can’t currently afford it set it as a “prize” or a “reward” to get for yourself at some future time when you have reached a predetermined wealth, income or other target or goal.  Don’t pay for things on credit that you can’t afford.  Credit expense (interest paid by you to others) is a significant drag on wealth building and can derail the best laid plans.

e.      Avoid impulse buying – Impulse buying is one of the leading causes for “unneeded” spending.  To help avoid impulse buying I recommend that you write a shopping list before you go shopping and purchase only what you have written on the list.  Avoid the marketing gimmicks and sales/peer/child/significant-other/etc. pressure by sticking to a shopping list.  This discipline is one of the best tricks to staying on a budget.

III.                Develop a budget

a.       Keep it simple – Developing and sticking to a budget for many people are as difficult as developing and sticking to a diet.  Many people try but few succeed.  I don’t have a good answer for the diet issue, but for the budget issue my answer is simple:  “spend less than you earn!”  That is the fourth “secret” to good money management.  The secret for success in every budget lies on the spending side.  Most of us can’t control how much we make, but we all can control how much we spend.  Throughout my life, no matter how much my income has been, I have always lived on less than I have earned.  My motto is “It isn’t how much you earn; it is how much you spend that determines how much wealth you will have at the end of the day.”  If you want a simple budget write something like this:  “This month I will not spend more than 75% of my income.”

b.      Pay yourself first – Always put money away for you.  Once you are spending less than you earn put that extra money to use earning you money.  Open a brokerage account and start investing that money.  Of course, part of paying yourself is also setting aside money for those special “prizes” and “rewards” you have chosen for hitting your financial milestones, targets and goals.  Little rewards along the way will help you mark progress and stay motivated to continue the journey.

c.       Adjust your budget to pay yourself more – As your spending decreases and your income increases adjust your budget to say something more like this:  “This month I will not spend more than 50% of my income”.  Make it a goal to decrease your spend to income ratio month over month and year over year.

IV.                Open an online brokerage account

a.       There are several online brokerages available (e.g. E*Trade, Scottrade, TradeKing).  I have used E*Trade (etrade.com) for many years now and I have been very pleased with their low fees, ease of use and great customer service.  Setting up an account is simple and can be done almost completely online.  One of the many advantages of online brokerage accounts is their low brokerage fees.  For example with E*Trade you pay $9.99 or less (some trades are free) for each purchase regardless of the size of the purchase.

V.                  Start investing

a.       Put your money to use – Take that money you are paying yourself from Section III.b. above and start buying securities with it.  The fifth “secret” to good money management is to get started.  The younger you are when you get started and the more you invest consistently the more you will have at the end of the day.  In Lesson 2 I will review the three main investment vehicles and help you understand how each one can be used to help you build wealth.

Appendix A
A sample list of expenditure categories

Auto	Create a subcategory for Auto
	·  Gasoline
	·  Loan
	·  Miscellaneous
	·  Parking
	·  Service
Bank Fees	Create a subcategory for Bank Fees
	·  Overdraft Fee
	·  Service Fee
Becky's Living Expense	Create a subcategory for Becky's Living Expense
Cash Withdrawal	Create a subcategory for Cash Withdrawal
Charity	Create a subcategory for Charity
	·  Trusts
Childcare	Create a subcategory for Childcare
Clothing	Create a subcategory for Clothing
	·  Casual
	·  Shoes
	·  Work
Crafts	Create a subcategory for Crafts
Credit Card Pymt	Create a subcategory for Credit Card Pymt
	·  Interest
	·  Late Fees
Delivery	Create a subcategory for Delivery
	·  Air
	·  Ground
	·  US Postal Service
Education	Create a subcategory for Education
	·  Board
	·  Books
	·  Fees
	·  Tuition
Exchange Fee	Create a subcategory for Exchange Fee
Food	Create a subcategory for Food
	·  Dining Out
	·  Groceries
Gifts	Create a subcategory for Gifts
	·  Anniversary
	·  Birthday
	·  Holiday
Healthcare	Create a subcategory for Healthcare
HOA fees	Create a subcategory for HOA fees
Home Owners Insurance	Create a subcategory for Home Owners Insurance
Home security	Create a subcategory for Home security
House Purchase	Create a subcategory for House Purchase
Household	Create a subcategory for Household
	·  Furnishings
	·  Homeowner Fees
	·  House Cleaning
	·  Laundry Services
	·  Maintenance
	·  Yard Service
Insurance	Create a subcategory for Insurance
	·  Auto
	·  Health
	·  Home/Rent
	·  Life
Investment Expense	Create a subcategory for Investment Expense
James' Living Expense	Create a subcategory for James' Living Expense
Job Expenses	Create a subcategory for Job Expenses
	·  Air
	·  Auto/Taxi
	·  Dining Out
	·  Entertaining
	·  Gifts
	·  Lodging
Leisure	Create a subcategory for Leisure
	·  Books/Mag/News
	·  CDs
	·  Club/Gym Fees
	·  Cultural Events
	·  Entertaining
	·  Membership Fees
	·  Miscellaneous
	·  Movies
	·  Sporting Goods
	·  Subscriptions
	·  Toys/Games
	·  Video Rental
LoanPymtsTaxed	Create a subcategory for LoanPymtsTaxed
	·  Mortgage Interest
	·  Student Loan Interest
LoanPymtsUntaxed	Create a subcategory for LoanPymtsUntaxed
	·  Auto
	·  Auto Interest
	·  Late Fees
	·  Miscellaneous
	·  Mortgage
	·  Student Loan
Medical	Create a subcategory for Medical
	·  Dental
	·  Doctor
	·  Eye care
	·  Hospital Fees
	·  Miscellaneous
	·  Prescriptions
Miscellaneous	Create a subcategory for Miscellaneous
Misty's Living Expense	Create a subcategory for Misty's Living Expense
Office Supplies	Create a subcategory for Office Supplies
Personal Care	Create a subcategory for Personal Care
	·  Barber
	·  Spa/Salon
	·  Toiletries
Pet Care	Create a subcategory for Pet Care
	·  Food
	·  Grooming
	·  Supplies
	·  Veterinarian
Rental Vehicle	Create a subcategory for Rental Vehicle
Savings	Create a subcategory for Savings
	·  Christmas
	·  Education
	·  Home
	·  Miscellaneous
School Supplies	Create a subcategory for School Supplies
Tax Related	Create a subcategory for Tax Related
	·  Child Support
	·  Federal Income Tax
	·  Federal Income Tax Prev Year
	·  Home Improvement
	·  Home Loan
	·  IRA Contribution
	·  Job Expense
	·  Local Income
	·  Medicare
	·  Miscellaneous
	·  Other
	·  Property
	·  Social Security
	·  State Income Tax
Transfers	Create a subcategory for Transfers
Travel	Create a subcategory for Travel
Utilities Electricity	Create a subcategory for Utilities Electricity
Utilities Gas	Create a subcategory for Utilities Gas
Utilities	Create a subcategory for Utilities
	·  Cable/DigitalTV
	·  Cellular
	·  Garbage/Recycle
	·  Gas/Electricity
	·  Internet Service
	·  Miscellaneous
	·  Public Transportation
	·  Telephone
	·  Water/Garbage
Vacation	Create a subcategory for Vacation
	·  Air/Train/Bus
	·  Auto/Taxi
	·  Lodging