Hi. We're going to continue learning a little bit more about savings and investing. And we're going to learn a little bit more about two major types of investments vehicles that are very commonly used today. Either directly, or through other types of accounts like mutual funds. So, we're going to begin by asking the simple question, when investing our money. Do we want to be an owner, or do we want to be a lender? What's the difference? So, let's start off by thinking about what's the context of investing? Why are there stocks? Why are there bonds? Why do these things exist? Well to put it bluntly, it's so that companies can get capital. So, if we think about how companies function, right. They might start up. And when they're starting up they're going to have heavy expenses. Likely no dividends. No real money that they can pay. They're like a person, right? They require a lot of help to kind of go forward. Then they might start going through a rapid growth phase. Where they begin to hit a technology stride for example. And this can include lots of things. Genetics, biotech new types of gaming systems. All of these things are constantly kind of increasing there. So, industries go through a life cycle. They then get into this growth consolidation phase, where the industry itself kind of starts coming in, we get some clear market leaders that are happening. We move into maturity where companies have moderate growth, and then into decline. So, as we think about this, what's the role of securities for these companies? Well, especially in that earlier stage, where they're trying to get started, they're going to require some level of capital coming in. Because, they might not actually be generating that much revenue themselves yet. So, in order for a company to get the R&D that it needs to. In order for it to make the growth. Open those stores that it might need. Engage in the research. It has to get that capital. They can do that by issuing ownership shares, we call stock in the company. And they do that, and they can sell those. Just investors who buy them in that company. On the IPO market, when they first offer those shares, goes to the company. They also can take on loans. Now, they can borrow money, of course. The same way any of us can, but many ways in which firms are going to get the money they need for borrowing is to spread the loan out among lots of investors, and we call that bonds. So, stock is going to be taking a piece of ownership in a company. Bonds are going to be being a creditor of the company. Which one is better? Well you'll find most companies are doing a little bit of both. Some do maybe more of one than the other, but the fact is a lot of companies use a balance of equity and debt in order to make sure that they're financially smooth and solvent for their, for their life cycle. So. Let's think about these, then, a little bit more. How do we access these? Well, we talked about these briefly. But, ways in which we're going to access these are cash accounts and margin accounts. These are commonly referred to as brokerage accounts, and we'll explore margin accounts in just a moment. A cash account is very simple. You put money in the account, that's what you have to invest. We talked a little bit in previous discussions about IRAs, and employer provided plans and education plans. And all of these are ways in which we can access these investments. Let's think about buying stocks in particular. In general, there's two major ways we can treat stocks. Now what is it you've heard about making money in stocks? Buy low, sell high. So, if that's the method we're going to, that we want to buy, and then potentially sell over time, we think of this as often being long on the stock. And that's what we would think of as buying the stock. We're going into it, we're hoping it grows in value. But what if instead, we want to sell high then buy low. Did you know you could do that? That's called short selling. So, this in actuality means that we're borrowing shares from somebody else and selling them today. And then we hope the price goes down, because at some point we'll have to buy the stock back and give it back to the person that we borrowed it from. This is all handled through a brokerage firms. You may think, do I really have to call someone up and do this? No, no, no, your broker or dealer will help you out with those types of arrangements. There's lots of rules governing these types of accounts as well in terms of they can only happen when the price is going up, not when the price is going down. But short sales can be another way that we think we can make money. Again, we're making a little bit of a bet. As to the fact that we're pretty sure that the stock is going to go down. If the stock goes up, when we short sell, that's a lot of risk we've taken on and we can potentially face a pretty serious loss. Now what about this margin account? Well, the margin account is really the fact that we are able to borrow additional funds, to change how we're making our investments. In other words, we're not just putting up our money. We're potentially putting up the, a firm's money as well, a line of credit, if you will. Now, you may think, well this is great! I only have $1,000 to invest, lemme borrow money from a firm and I'll be able to invest a lot more. That's not really the way margin accounts work. We don't want to use a margin account when we don't really have any money. Margin accounts are sort of the opposite. They're a way that we can leverage money that we have, but we may not want to tie up in this investment, but we still have access to it. So, typically we have to put up 50% to 60% of the value of the investment. You might be able to borrow the rest. But on the other hand if the value of the investment goes down, we may end up having to put more money into the account, and that's called a margin call. So we think a little bit about this idea because margins come up with their own little risk then in a sense of that, and they still require that we have a lot of liquidity. So, just want to distinguish between the two, because you may have certainly heard that term before. Now how do we buy stocks? Well, many common ways we go about this. We talked about going long and short. But, even when we go long, we potentially want to put some specifics on it. We might want to say, just buy it at whatever's happening in the market today. That would be called a market order. We might want to buy or sell it at a specific price. And that can be a limit order. We also can have a stop order. Sell a stock after it hits a certain price. This is a way of making sure we don't lose too much money. Let's say we had to sell our stock below or above a certain price, so that we made sure we guaranteed a certain amount of profit, so we might use that. And, of course we can also use a discretionary order leaving a little bit of it up to our broker, dealer, to determine the appropriate buy or sell price. These are just some of the basic types of orders they can have. And obviously as we know, it can always get more complicated than that. We talked about the different markets then for equities too. So, we mentioned that a reason why securities exist is that firms potentially want to get money to invest in themselves and raise capital. That's what we think of as the primary market for equities. In other words, when firms are issuing stock, for the first time, to the public, we refer to this as an IPO, an initial public offering. And, it's in this market, when firms actually get money for their investments. Right? The money comes from investors to the firm, to introduce the stock to the markets, themselves. That primary market is sort of one thing we might think about, but that's not as common for us to participate in. More commonly we're participating in things like the secondary market, where investors trade securities with other investors. Unless a firm is one of those investors they're not actually making money any more on the trade of their stock. You have Apple for example that issued stock. Want the first time, they took in money for that. But the fact that you or I may sell Apple stock on the market to each other, Apple doesn't see any of that money in particularly. Now, there's also a 3rd and 4th market that are used more for over the counter trades also for 4th market which are more for institutional traders to trade without brokers. So, there's different options for it. The average investor is participating in the secondary market, and maybe the primary market as well, if they're lucky enough and have the right capital to get involved in an IPO or Initial Public Offering. So, how do we make money on stocks? Dividends. Right? Positive net income per share. In other words a company's made money. They have money left over after paying all their bills, and employees and making capital investments, they have that money. They don't have to pay it to shareholders, but many of them will choose to do so. And so, that's an important piece of it. We can, of course, if the stock goes up in value and we sell it, we have a capital gain. And then we say to ourselves, well, these are the two major ways we can make money on stocks. What's more important? Well, to be honest with you, it depends upon where you are in life. Capital gains, we don't have, just because a stock goes up a little bit, we don't have to sell it. But that's what we refer to as growth. So, the younger we are, the longer time we have until we need our money, the more we're probably growth oriented. Because that will produce a pretty high return. If for example we are needing income sources. Maybe we're close to retirement. Maybe we need to augment our income during retirement. Then dividends can be pretty beneficial to us, because they would pay out quarterly for us, and we would get a certain amount of income all the time from them. So, again, what we need from our investments tells us which one's more important. They're both pretty darn good. Now, what about types of stocks? Well, there's a few types of stocks to think about. We're just going through some common language here, to make sure we understand a little bit of what we're looking for. So you've probably heard the term blue chip stocks. These are real high quality, well established firms and they typically pay pretty consistent dividends. They don't have to be, but blue chip stocks are often though of that, as things that we think of as bellwethers of the market. We have defensive stocks, ones that are less impacted by economic fluctuations. So, certain companies, for example, if we go into a recession, are hit harder than others. And so as a result, right, we'll see that some companies are less resistant to it. For example, in an economic downturn, certain things we still always need, like consumer durables. We always need diaper's, my wife always says. So, we might, for example, think about some things like that. Certain products will kind of be used regardless of the economy. Other products, like luxury goods or vacation or tourism related, they all suffer a little bit more in a recession than others. And so, those may be cyclical stocks, where as the economy goes up and down, these stocks tend to have a very similar pattern. We could have growth stocks, where they're really there growing at a rate faster than the overall market is. And these may be younger firms, ones that have new innovations, new products that are coming out there. We've historically in the last several decades seen tech companies being a lot of this growth market for us. We continue to see new and emerging market leaders. Companies that are in more of a mature phase, remember the industry life cycle probably paying more dividends, and as a result they, we think of them more as income producing stocks. And then of course we have value stocks. Now value stock, is a term used when we think of company's that are fundamentally under valued, meaning that if we look at the numbers and say what should the stock be worth, it's worth more than what people are currently paying for it. And so one of the things we talk about efficient markets, is that if that's true, the stock price will adjust, to what the theoretical price ought to be. That's one of the nice things about it. Now, how do we track stock? When we say the market's doing well, the market's not doing well, we're typically referring to the broad measures of the market, indices, and so most common ones we hear about are the Dow Jones Industrial Average, which is the 30 really big companies that are out there. The one that we often refer to as the market portfolio is called the S and P 500. Which is 500 stocks. Right? And they're reflective of things like size, liquidity, industry. So, it's pretty respective and represents a nice broad stroke of what the market has to offer. These are commonly referred to as large cap stocks, larger companies. There's not a lot of small companies in either of these. And then they also have the NASDAQ, which represents this electronic trading, and focuses a lot on technology and internet. So, in any given newspaper, in any given news show or business show, you'll often hear these indices referred to pretty regularly as representing the performance of how the market's doing. They'll say, the market did well today. The Dow was up, the S&P was up, the NASDAQ was up. You'll hear those phrases, and really, they're talking about these measures that help to capture, right, in one number what sort of the value is of the market as a whole, how it's doing. Now, in the rules of investing we learn in particular about. Things such as how prices are reflected in the market, but it's important to know that there are still people who are analysing these securities. So, fundamental analysis is the examination of the value of a company based upon the public data that they're required to report. And they are required to report these if they're a public company. So, you might, for example, look at how their. Ratios are doing relative to their industry, relative to their peers, do they look like they're stronger in certain ways, maybe with cash flows, maybe in dividend yields. So, in other words are they looking pretty good on the books, relative to their competition. So, it may at least help you decide within an industry, do I want company a or do I want company b. There's also people who believe in technical analysis, as well. Right? And this is the idea of looking at price and volume data. Looking for patterns that we might see. In other words, trying to get a gauge of investor behavior. Getting a sense of momentum for a stock. Whether or not a stock, for example, is moving forward and was likely to keep doing so, because of the investor sentiment surrounding the stock. So, people will use different types of techniques to get at this. Right? And when we think of fundamental analysis, do we ignore the numbers? Well, probably not, but the question is whether or not we think those numbers can help us to outperform the indices. And so, when we talk about that somebody doesn't beat the market, what we're saying is that you're probably not going to typically beat, what the S&P 500 is doing as an index just by investing yourself. And so that's the notion of saying can we get ahead with these techniques, or do these techniques simply give us another way in which to make choices about our investments. Always kind of a tough question. Let's think about a few key things here with respect to stocks. Number one is the dividend yield. So, if we are looking for income production from a stock, then we think of the cash dividend per share, divided by the market price. So, in other words, if we're looking for income production from a stock, higher dividend deal is better. We also might think of something called the PE ratio, which is the price relative to the earnings per share. So, often times when we think about this, this range is often from 15 to 40 on average for most companies. And a way that we can think about this is saying, well, how does this look relative to its peers. So, for example, if were looking at airline stocks and we saw three or four of them and we're trying to choose to invest in. We might say well this one has a better PE ratio than the others. This one is, has way to much price relative to its earning. As this price earnings gets higher, right? We're, you're potentially start seeing what the stock may in fact become overvalued especially if for example, you had a value of 70, and every other stock in the industry was more like say 25. So, we might be concerned that a particular stock's price is overvalued. Remember it's the price divided by the earnings per share. And those earnings are what are reported quarterly for us. So, we often get that type of information from, regularly. And see, how are we doing relative to what the earnings are. If a company doesn't have positive earnings you may see price to sales, or price to book ratios as well. And we use them all very similarly. Comparing them from the peers and saying what should these be like. So, value investing has been a very popular theme lately, especially in the markets. And, when we say lately we mean over the last decade or so. And this goes back to that issue of fundamental analysis, that people might be looking for the value of stocks, meaning that is the stock selling at what we think it should be, or, right, is it selling at more or less than that. Two common ways you might look at this. One is called the dividend discount model, where we actually look at the present value of the expected dividends. So, if a company is paying dividends for us, then really what the stock is worth to us today, is the present value of all those dividends for the lifetime of the stock, which really goes on for as long as you can think. We don't really know when a stock would stop existing for example, so we tend to take it out in a model called a perpetuity model. If a company doesn't pay dividends, we might be using different measures of cash flows per share. So, free cash flows is one that's often commonly used, too. And that involves a little bit of accounting trickery, to get to a particular number. We won't go too much into that today, but suffice it to say that this is a lot of what value investing is, too. Is looking for stocks that are fundamentally undervalued, relative to what they should be pricing upon. So, the idea is that we invest in those stocks, knowing that they'll eventually adjust up to their hypothetical prices. So, that helps us to get a little bit of sense of equities for us there, if we want to be an owner. What if we want to be a lender? Well, if we remember, and we go back to security li, security market line, we know that bonds were considered a little bit less risky than stocks. They're typically referred to as fixed income investments. And that's because the interest that's paid, because it's a loan, is paid regularly. In fact, if they're not, much like a creditor can do, you can say, we want our money. So, right? There's a little bit of difference between it, because lenders have a little bit of higher rights, associated with getting access to the money their owed, than owners do. Let's look at bonds. In, in essence, you loan the price of the bond to receive the interest, and then the face value of the bond. This face value is paid at maturity. And this is just based upon the length of the bond issue. It could be a three year bond, a five year bond, a seven year bond if it's a treasury it could even go up to 30 years. Bonds may actually be convertible in nature and no, the top doesn't come down. What we mean is that bonds can potentially be exchanged for stock shares. Not every bond has this feature, but that may be an attractive component for you, depending on what your investment priorities are. Bond, companies can also refinance their debt, so a bond may be callable in nature. In other words, this says that a company may have a right with a bond to pay it off early for a reduced amount of interest. So, in other words you won't get all the money that you expected to over the life of the bond, but you're going to get it quicker. Now, bonds can potentially be secured, they could be mortgaged back or they can be debentures. In other words, a debenture just means it's backed by the good faith of the company. The fact that we just believe that they'll pay their debts off. Not necessarily a bad bet, but we'll see that there's going to be a whole rating system that helps us to judge just how credit worthy they are. kind of like a FICO score, but for companies. So, how do we make money on bonds? Well, number one, zero coupons bonds or one phenomenon a lot of us have gotten these for various birthdays, and others major life events for us. We buy a bond at a discount and we get the face value at maturity. Series EE bonds are one example of this from the treasury, but there's other ways in which we'll see zero coupon bonds as well. Coupon bonds, on the other hand, pay a semiannual coupon. So, every six months you receive an interest payment. Based upon, right, the level of the coupon rate, as well as of course what the face value is of the bond typically, that's a $1,000 face value. So, if we have a 10% coupon rate right, we would say that's $100 a year for a $1,000 bond, so we would get $50 every six months. So, coupon bonds actually got the name because, back in the day, there was really a bond with coupons attached to it that we would present for our payments. Nowadays, it's all electronic recording, of course, so we just get that money automatically without having to hand in a coupon. So, a few other things, too, is that bonds can sell for less than their face-value, or more than their face value. If it sells for less than its face value, in other words a bond sells for $900 with a face value of $1,000, we call that selling at a discount. A bond may also sell at a premium, meaning that for that same $1,000 face value, the bond may actually cost $1,050. Why would a bond be at a premium or a discount? Depends a lot on the coupon rate. Coupon rate may be high enough to where you may pay more than the face value of the bond, because your going to get a 10% coupon on it. That might actually be still worth while for us. So, we'll see that that's one possibility too in terms of how we make money, the price we paid, versus potentially the face value of selling it. Where's this debt come from? In other words, who wants to borrow money from investors, Federal Government, State and Local Governments too, Corporations including banks and their using these all for funding various activities and investments. State and Local Governments for example may use it to build roads, build a toll road for that pattern. Corporations may use it to build a new plant or buy new factories. Usually not just for ongoing expenses, but for some sort of capital investment. And the federal government of course uses this too, right. For different initiatives that it needs to take. So, when we think about government bonds right, we have the risk free in general. There' no default risk. The treasury bill in particular we've talked about this. We have t bills which are a little longer in nature than right for us. So they go as low as 13 to 52 week maturities. We have treasury notes, these are one to ten years. We have treasury bonds, which are ten to 30 years, and then of course, we have those savings bonds which aren't marketable. The other potentially, there's actually a market for, but not for the savings bonds. There's agency bonds. Things like Freddie Mac used to have them, Ginnie Mae, Fannie Mae, and they used these bonds to produce capital for lending for mortgages, for example. State and municipal bonds we mentioned as well, but there's a neat little trick with these I want to highlight. These are often referred to as general obligation bonds, so in other words, they're simply backed by the full faith and credit. And the taxing authority of a government, or their revenue bonds where the bond has been re, repaid from earnings from a project. Perfect example as I said before is a toll road, we issue a bond, you build a toll road. You pay the bond back with revenue generated from the toll. So, there's different ways in which those can work. The interesting things about municipal bonds. They're tax exempt interest. You didn't know that, right? So, think about that for a moment. That means these particular bonds, the interest that they pay, doesn't face taxes at all. We don't have to hold it in a special account to do that, it's just the nature of the bond themselves. So, it's important then that if we want to compare a taxable bond. Like for example a corporate bond to a municipal bond that we distinguish between the taxable equivalence of them, because one of them will face taxes and one of them may not. And, as a result we need to make sure that we're comparing apples to apples with these. So, we use this particular equation that tax-exempt yield. So, in other words we say, what would this tax exempt municipal bond be worth. If it pays taxes. So, we take the tax exempt yield divided by 1 minus our tax rate, MTR is the marginal tax rate, to give us what would be the taxable equivalent. We can then compare that to a corporate bond which would face taxes and say, which one of these is higher? So, in other words, we take a taxable bond, compare it to a taxable equivalent yield. And whichever one is higher is really the better deal for us on a tax-adjusted basis. So, another type of fixed income investment, CDs also, these aren't bonds, but we are lending money to a bank, or credit union as a result of this. These are time deposits. And again, which is a bank issuing a CD? When they have money committed to them they can turn around and loan that money back out to other people. So, as I mentioned before there's a credit score, a credit rating for bonds as well. We have Moody's, we have S&P. And they have investment grade bonds. So, for example they might be Baa or triple b or better. The top grader are going to be right triple A, and we've heard about those before too. There's also high yield bonds, these are typically refered to as junk bonds. It's a little bit of a misnomer there, they're just simply a little more risky, they don't have quite as high of a credit rate. So, if you will to equate them to the mortgage market, we have prime mortgages, and sub prime mortgages. Bonds are kind of the same way, we have investment grade and then we have ones that are a little risky. It's not to say that they're not all worth investing, but it is to understand that you potentially take on more risk in doing so. All the more important to having a diversified portfolio and bonds as well. So, what are some of the risks to bonds? Well systematic risk of course. Interest rate risk in general. As interest rate, right, as interest rates fall, bond prices increase and vice versa, right? Because they become more or less attractive, given what's going on overall with interest rates in general. We may have reinvestment rate risk, in other words, our bond matures and we want to buy more bonds. Maybe there's no good bonds to buy at that time. Some bonds, if we look at T-bills, are just barely keeping pace with inflation, so we may have some concern over purchasing power. And of course we may deal with exchange rate risk too if we're dealing with international bonds. On the idiosyncratic risk side, what are we concerned about? Well, to put it bluntly, we're concerned with the company paying us back. The same way anyone who loans you money is concerned you're going to pay them back. So, we're worried about things like default or credit risk. In other words, is that a high yield bond, and is there a chance they're not going to pay me back. There's call risk. In other words, a company wants to retire the debt early. Means we're going to get a little less return than we banked on. May not be a big deal, but it could potentially interfere with our goals, could make a difference in terms of the type of money we were expecting. And then there's liquidity risk. Right? Bonds, we often take, and buy, and hold until maturity. We can, potentially, sell them, but the reality is that we don't necessarily really have immediate access to that money, should an emergency arise. So, there is liquidity risk also associated with bonds the same as there is with stocks. Now let's think about Bond Valuation. So, as always I'm taking the theme back that we talked about from stocks as well, what's the most I should pay for an investment? Typically it's the present value of the money we expect to receive from it. So, what's the expected value, or the present value of a bond. Well, think of it this way, we are going, we pay for a bond, we are going to get a mature, or we're going to get a par value for the bond when it matures, and then we're potentially get an interest payment over the life of the bond, so we want to think about. All of that money plus what we paid for it, what's it worth today? So, for example, we can think of this as the present value of the cash flows. Because we have two payments per year, we, on our calculator, we would set this as a payment for year for two. The future value of the bond is the face value at maturity. The payment is going to be the semi-annual coupon payment, in other words, if we have a 100, if we have a 10% coupon rate, on a $1,000 bond, it would be a $50 payment, because we get half of $100 twice a year. The number of years, right, that this bond is good for, plus the relevant discount rate that's out there, typically based on the yield to maturity for comparable bonds. The present value is the price that we paid for the bond. So how does this work? Well, let's assume a three year bond that pays an 8% coupon payment semi-annual with a face value of $1,000. Comparable bonds have a 10% yield. What should this bond cost? Set our payments per year to two. Second input, so we have all clear. Enter in our interest rate, our relevant discount factor, our payment, three second N, so that we reflect sort of the number of payments we're receiving, plus the future value of it. So, the most we should pay for this bond $949. So, if the bond is priced about that, that's a pretty good price for us to pay for it. If the bond is priced a lot more for it, it maybe a little overvalued. We might want to think about any assumptions we made in our calculations. But we'd certainly be concerned about paying a lot more than that for this bond without more information. So, there's also a few other things to think about too, the yield of a bond, so in particular, there's the current yield, which tells us the cash flows for the year, based on the current price. This is simply the dollars in annual interest divided by the current market value. This helps us to understand a little bit about sort of the annualized productivity for that bond, in other words, how much money are we going to get for the amount of money we're putting up for it. So, as always, right, if we're comparing, using this to compare across bonds, we'd like a higher current yield. So, yield to maturity for a coupon bond is the promise compounded rate of return based upon on what we paid for it and if we hold it for maturity. And of course our financial calculators can do that for us as well and there's a lot of on-line calculators we can use, to also calculate the yield to maturity for a bond. Let's look at a simple here. A 30 year bond with a 9% semi annual coupon that sells for 1249.45 and has a face value of $1,000. What's the current yield? And what's the yield to maturity? Right? The current yield is 7.2%. And the yield to maturity is 7%. Okay, so and again why is that? Well, it has a lot to do with simply the fact that the bond is selling a premium itself. So, so we're not too surprised by that particular feature as a result. So, why do people sell bonds? Well, if interest rates have dropped, this may make our bonds more valuable. If the bond rating drops. A bond is potentially more risky, but may not actually be me, more rewarding, because the interest or coupon rate on the bond didn't change, because the bond rating dropped. So, it may simply not be an appropriate bond any more. So these are some of the reasons why people will sell them, but as always, we don't want to try and time the market, but we do want to understand what is, what is So, just to kind of go back as we've looked at these different types of investments. I want to just bring us back to looking at how do these investments compare with each other. So, again taking a look at treasury bills, bonds and stocks, I know we've looked at this chart before, but there's a reason why when we talk about the rules of investing that asset allocation is so important. And that's because again, what we really want to think about in the end is do we get enough rate of return so that we're getting the maximum amount of production we can out of our investment, based upon our risk tolerance and of course based upon the our goals that we need to have. How much money do we need to have lined up? Of course time will play a factor in this as we've talked about. Stocks are a great investment for the long run, but are certainly more volatile in the short run. So, we'll often see that we require a healthy mix of these. In shorter time horizons, a couple of years, up to ten or 15 years even, we're probably going to need some balance between stocks and bonds, so that we have a nice smooth return as much as possible over the time. The longer our time frame, the more we can be stock-heavy of course. Which is another important consideration. So, to recap, investing often time begins with a simple discussion of, how much return do I need to have? All right, and do I want to be an owner, or do I want to be lender to get there? Sometimes the choices, I probably want to do a little bit of both. So, that I can achieve diversification. We'll explore further how we can efficiently get to these investments, as we begin to take a look at mutual funds in our next presentation.