Two ways to make money with stocks

Two ways to make money with stocks

stocks-make-more-moneyHave you ever stopped to think about why a unit of stock is called a share?  What exactly are you sharing, and who are you sharing it with?

You may recall that stock represents ownership in a company. As an owner, you are entitled to all the rights and responsibilities of a business owner. In a publicly traded company, your responsibilities are limited to financial commitment to the company; the amount you paid for your shares of stock. Your worst case scenario is that the company becomes insolvent and your stock becomes worthless. Your liability is said to be limited because no one can come after other assets you may have to cover an obligation of the company.

You also enjoy certain rights. The first is the right to vote for the board of directors. The shareholders, as an entirety, elect a board of directors to hire and direct the executive management team. The company’s executives hire and supervise managers who carry out the plans and direction of the executive management team. The managers, in turn, hire the employees who perform the functional tasks of operations.

The second right shared by the stockholders is a right to their proportionate share of profits. As the company makes money, the board of directors has a choice to make. Do they give the stock holders their share of the profits, or do they keep the profits in the business with the intent of growing and expanding the business with the expectation that greater profits can be generated in the future? If profits are kept in the business, the accounts call them retained earnings. Profits distributed to stock holders are called dividends.

Some investors prefer dividends. You have heard the expression “a bird in the hand is worth two in the bush”. Dividends are usually paid in cash and the investor is free to do whatever they wish with their share of the company’s earnings. They can pay their bills, invest in another company, or simply save the cash. Some companies offer investors the opportunity to use their dividends to purchase more shares of stock without having to pay regular trading expenses. These programs are known as DRIPs or Dividend ReInvestment Programs. But regardless of which direction the stock holder takes the tax man commeth.  In 2013, the maximum income tax rate on dividends is 20%.

Often it is the tax which motivates investors to shun dividends. Those investors prefer that the company retain its earnings and reinvest in itself. Their hope is that as the company grows in value, so will the price of the stock they own. As the stock value grows, so does the worth of the investor but taxes aren’t an issue until the investor actually sells their stock. If the investor sells the stock for more than they paid for it, the difference is a capital gain. As long as the stock was held for a year or more it is currently taxed at the same rate as dividends. If the stock was held for less than a year, ordinary income tax rates apply.

So the two ways to make money with stocks are Dividends and Capital Gains.

Investors should have a clear understanding of their strategy before purchasing stock so they know the best way to evaluate any potential stock purchase.

Key Terms

  • Retained Earningsprofits earned by a company which are kept by the company to fund future growth and development.
  • Dividends stock holders share of the company profits which are distributed in cash.
  • DRIP – dividend reinvestment program. A program which allows shareholders to use their dividends to purchase additional shares in the company without paying trading costs.
  • Capital Gains the profit made by selling a stock for more than an investor paid for it.
  • Capital Loss the loss incurred by an investor if they sell their stock for less than they paid for it.

How Interest Rates Affect Bond Prices

How Interest Rates Affect Bond Prices

Flows Into Stock and Bond FundsSince the bottom fell out of the stock market in 2008, investors have been shifting money from stocks into bond funds. Since 2007, there have been $1.39 trillion invested in Bond Funds versus $193 billion in stock funds. The most logical explanation is an attempt to find income and safety, but are bonds truly safe? To explore that question we need to understand where interest rates are now, where they will be in the future, and how changes in the interest rates will affect bonds.

Interest Rates

In response the financial crisis, the Federal Reserve (the Fed) lowered the federal funds rate to a historic low of 0% – 0.25% and they have remained there ever since. In their recent guidance, the Fed announced their intention to keep the rate at that low level until the unemployment rate falls below 6.5% which they predict will happen in 2015. The accuracy of their estimation can be argued but it really isn’t they key issue. What is important is that interest rates are as low as they will go and the next change in interest rates will be up. When that happens, bond investors may find their portfolios in trouble.

Bond Prices

The rule is simple. When interest rates go up, bond prices go down.

Suppose you buy a $1000 bond today which pays 5% interest. Every year the bond will pay $50 until the bond matures and then you receive the $1000 back. You pay $1000 for the $1000 bond. In investment terms, you just purchased the bond at Par Value.

Tomorrow, the same bond issuer raises the interest rate on new bonds to 6%. Those bonds pay $60 every year until the face amount is returned to the investor. If someone else is looking to buy a bond, they would obviously chose the 6% bond for their $1000 over your 5% bond… unless you were willing to sell your $1000 bond for less than $1000. At some discounted price, the 5% bond is just as attractive as the 6% bond for $1000.


Relationship between bond prices and interest rates: Why bond prices move inversely to changes in interest rate

 

Bond fund buyers need to be aware (or should they beware?). There is no argument that interest rates will be going up. The only unknown is when it will happen. When it does, the prices of the bonds in bond funds will fall and the fund values will go down.

Key Terms

  • Par Value – the face amount of a bond. It is what an investor paid for the bond when it was initially issued and what will be repaid to an investor when the bond matures.
  • Discount Bond – a bond which is currently trading for less than its par value.
  • Premium Bond – a bond which is currently trading for more than its par value.

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