“Never depend on a single income; make an investment to create a second source.”
Many know that investing is one of the best ways to grow our wealth, but do we all know what kind of investment vehicles are available? Everyone is familiar with stocks, some are familiar with bonds, and most are unfamiliar with derivatives. The use of the different securities types allows us to invest as we wish, depending on our risk tolerance.
Investing in stocks is the sexy part of investing, but the bond market is larger than the stock market by about double! The derivative market is far less known, but it provides value to those who use it as a way to minimize losses.
In the old days, before the internet, when you bought a stock, we were issued a paper document or note of some type. These paper documents served as the documentation of our investment and outlined the investment terms. These paper documents were known as securities and our proof of investment.
Bonds worked in the same manner, and the dividends or coupons the bond paid were from the actual coupon torn from the bond that we returned for proof of payment.
Ah…..the good old days.
Now everything is electronic, and all the proof is available on our investment account, and there is little need for the paper document.
In today’s post, we will learn:
- What Are Securities?
- What Are the Three Types of Securities
- How to Invest In Securities
- Long Term Returns of the Different Securities
- Investor Takeaway
Okay, let’s dive in and learn more about the three types of securities.
What Are Securities
What are investment securities, according to Investopedia:
“The term “security” refers to a fungible, negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly-traded corporation via stock; a creditor relationship with a governmental body or a corporation represented by owning that entity’s bond; or rights to ownership as represented by an option.”
Securities come in two basic flavors:
But, some hybrid securities merge securities with both elements of equities and debt.
Today, the term securities encompass a wide range of negotiable financial investments. For example:
What Are The Three Types of Securities
There are three main types of securities:
- Equities (stocks)
- Debt (bonds)
- Derivatives (options)
Equity Securities (Stocks)
An equity security represents partial ownership of a business. As a shareholder of a business (company, partnership, or trust), those shares come in the form of capital stock. There are two forms of capital stock, common and preferred.
As shareholders of the company’s equity, we are not entitled to regular payments, but many companies choose to return equity or money to shareholders via a dividend.
Of course, shareholders can profit from the capital gains from the sale of their equity security or stock. The shareholders report the losses or gains as a capital gain or loss on the shareholder’s tax returns, depending on how long the shareholder holds the security.
As a shareholder of the company, we do have limited rights via voting rights. Depending on the level of ownership, we may exert control pro-rata.
As a limited owner of the company, we have a residual interest in the case of bankruptcy; in other words, if the company declares bankruptcy, we are at the back of the line and will likely receive little.
Debt Securities (Bonds)
A debt security represents a loan or borrowed money that the company must repay. The debt outlines the term of the line, size of the loan, coupon payments (interest payments), and maturity or renewal date.
Debt securities encompass many different types:
- Government bonds
- Corporate bonds
- Certificates of deposits (CDs)
- Collateralized securities (CDO)
These debt securities entitle holders to regular payments of interest, known as coupons, and repayment of the principal, or loan. The repayment of the debt at the purchase price is independent of the performance of the debt security.
Debt securities do not include any voting rights, unlike an equity security.
The issues of debt securities typically are for a fixed term and are redeemed by the debt holder. For example, a 10-year Treasury bill redeems at the end of the ten years, returning the original principal to the investor.
Debt securities are available as secured (backed by collateral) or unsecured. If the debt is unsecured, it may be ahead of other unsubordinated debt in the case of bankruptcy.
Debt securities are ahead of the line with equity securities; debt holders generally receive something for their investment.
As mentioned earlier, the debt security market dwarfs the equity market, albeit less well-known. One of the largest investors in debt securities is Warren Buffett, yes, that Warren Buffett. He uses Treasuries as a short-term liquid store holder while he waits for his pitch.
Derivatives are financial instruments whose value depends on variables. The variables consist of stocks, bonds, currencies, interest rates, and goods. Derivative’s main goal is to consider and minimize risk. Derivatives minimize risk by insuring against price movements, up or down. The derivatives create favorable conditions for speculations and gaining access to different assets or markets.
In the past, the use of derivatives focused on balancing exchange rates for goods traded internationally. The traders used derivatives to help lock in set rates for different currencies to trade their goods.
Here is a breakdown of the four main types of derivatives:
- Futures – also known as futures contracts that are an agreement for purchase and delivery of an asset by two parties, and will occur at a future date—the futures trade on an exchange with standardized contracts. In futures trading, the underlying asset must be bought or sold.
- Forwards – forwards are similar to futures but don’t trade on an exchange, on transacting via retail. The buyers and sellers of the assets must agree on the forward contract’s terms and the derivative’s settling process.
- Options – options contracts are similar to futures contracts with the agreement between parties on the buying or selling of an asset at a future date. The main difference is options contracts are not required to complete the action of the contract.
- Swaps – involve the switching of one kind of cash flow for another. For example, swapping a fixed interest rate for a variable interest rate on a contract.
One other type of security is a blend or hybrid security, which includes both equity and debt securities characteristics.
Like bonds, hybrids pay a coupon or interest payment, but those payments are not guaranteed, unlike bonds. Hybrids also allow for conversion to securities at some point in the future.
A perfect example of a hybrid is the preferred stock that allows the holder to be in line ahead of common shareholders both in dividend payments and bankruptcy.
Preferred stocks are far more complicated than common stocks. They allow for different treatment, such as the ability to convert from bonds to stocks. Preferreds carry different rules, and even experienced investors are not familiar with this style of security.
How to Invest In Securities
All publicly traded securities list on stock exchanges, such as the Dow, S&P, or Nasdaq, for example. Here the issuers of the listings, equity or bond, can attract investors with their liquidity and market regulations.
With the advent of electronic trading via the internet, securities are now available for trading “over the counter” and directly with investors or by phone.
An IPO, or initial public offering, represents a company’s first public sale of equity securities. Following the IPO, any new stock issued, while being sold in the primary market, is now available on the secondary market.
Before the IPO, the equity securities are offered privately to local groups as a private placement.
In the secondary market, investors can exchange the assets for cash or capital gain. The secondary market is not as liquid as the primary market and not an ideal place for IPOs.
Any entity that creates a security for sale is the issuer, and those that purchase the security is the investor.
Equities represent a means of raising money, or liquidity, for an entity such as a city, company, or any other commercial enterprise. Companies raise a ton of money when they go public; the recent IPO craze is the perfect example.
Another great example of raising funds is the issuing of bonds. Cities, states, and municipalities raise funds by issuing municipal bonds. Depending on the enterprise’s circumstances, raising funds via a bond or equity issue is a better option than a loan from a bank.
The regulation of securities in the U.S. is handled by the SEC (U.S. Securities and Exchange Commission), which handles all the regulations of public offering and sales of securities.
Any public offerings, sales, and securities trades must be filed and registered with SEC’s state securities departments. The regulation of state security departments is by FINRA (Financial Industry Regulatory Authority).
In 1946, the Supreme Court established the definition of a security offering. According to the court, the definition includes:
- An investment contract
- Formation of a common enterprise
- The promise of profits from the issuer
- The use of a third party to market the offering
Long-term Investment Returns
Let’s take a look briefly at the returns we can expect from equity and debt securities.
All the data is taken from Professor Damodaran’s website and is based on an original $100 investment.
Staring in 1928 to 2020
U.S T Bond
Baa Corporate Bond
Now, let’s put the same idea through the last fifty years.
U.S. T Bond
Baa Corporate Bond
And finally, let’s look at the returns over the last ten years.
U.S. T Bond
Baa Corporate Bond
That is an interesting set of data, and we can see that equity securities over approximately one hundred years are a darn good return. But bonds over the last fifty is nothing to sneeze at either, especially with the nature of conservatism.
As an investor understanding the basics of the investments we make is a crucial base. Once having that base of knowledge, you can explore different ideas depending on your risk tolerance.
The basic evolution of risk follows this path:
- Bonds – safest
- Equities – less safe
- Derivatives – the riskiest
Many experienced investors use derivatives to juicing their returns, but it is a more risky strategy outside my comfort zone. I don’t partake of derivatives or options because they don’t appeal to my sense of safety.
There is enough risk in equities and debt for my sanity, and understanding how those securities move are enough of a challenge for me.
As we can see from the charts above, the returns over the long periods favor equities, but increased returns come with more risk when investors refer to risk; there a few ideas around that subject.
To Warren Buffett, the risk was the permanent loss of capital, i.e., bankruptcy. Avoiding permanent losses is one of the sure ways to ensure you will do well in the market over the long run.
To others risk, is the risk of your investment’s price falling, which is almost impossible to ignore if you invest for a long period. There will be market drawdowns, such as March 2020, but staying logical and in the market is the way.
Bonds offer more safety, albeit with lower returns. The bond market is far less sexy and not followed by the majority of investors. But for some, the use of bonds helps them invest for their goals.
Whichever way you decide to go in the investing world, knowing and understanding the different securities will help in that goal.
With that, we are going to wrap up our discussion for today.
As always, thank you for taking the time to read this post, and I hope you find something of value in your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,