The 3 Main Types of Securities, and Their Returns Over Time

Updated 4/28/2023

“Never depend on a single income; make an investment to create a second source.”

Warren Buffett

Many know that investing remains one of the best ways to grow our wealth, but do we know what investment vehicles we have available? Everyone is familiar with stocks, some are familiar with bonds, and most are unfamiliar with derivatives. Using the different securities types allows us to invest as we wish, depending on our risk tolerance.

Investing in stocks remains the sexy part, but the bond market offers us a larger opportunity than the stock market by about double! The derivative market remains far less known but provides value to those who use it to minimize losses.

In the old days, before the internet, you received a paper document or note when you bought a stock. 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 similarly, and the dividends or coupons the bond paid were from the 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:

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:

  • Equities
  • Debt
stocks and bonds

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:

  • Stocks
  • Bonds
  • Options Contracts
  • Mutual Funds
  • Mortgage-backed Securities

What Are The Three Types of Securities?

There are three main types of securities:

  • Equities (stocks)
  • Debt (bonds)
  • Derivatives (options)

Equity Securities (Stocks)

Equity security represents partial ownership of a business. As a business shareholder (company, partnership, or trust), those shares come as capital stock. There are two forms of capital stock, common and preferred.

A person sitting at a table with a computer and cell phone

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 selling 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 company shareholder, we do have limited rights via voting rights. Depending on the level of ownership, we may exert control pro rata.

As a limited company owner, 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 the company must repay. The debt outlines the term of the line, the loan size, 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, 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 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 remain available as secured (backed by collateral) or unsecured. If the debt remains unsecured, it may be ahead of other unsubordinated debt in the case of bankruptcy.

Debt securities are ahead of 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. Warren Buffett continues as one of the largest investors in debt securities, yes, that Warren Buffett. He uses Treasuries as a short-term liquid store holder while he waits for his pitch.

Derivative Securities

Derivatives are financial instruments whose value depends on variables. The variables include 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 gain access to different assets or markets.

In the past, derivatives focused on balancing exchange rates for goods traded internationally. The traders used derivatives to help lock in fixed rates for different currencies to trade their goods.

Here is a breakdown of the four main types of derivatives:

  • Futures –futures contracts that are an agreement for the purchase and delivery of an asset by two parties, 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 transact 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 an asset at a future date. The main difference remains not requiring option contracts 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 one on a contract.

Another type of security is a blend or hybrid security, which includes equity and debt securities characteristics.

Like bonds, hybrids pay a coupon or interest payment, but unlike bonds, those payments are not guaranteed. Hybrids also allow for conversion to securities at some point in the future.

The preferred stock offers a perfect example of a hybrid that allows the holder to be ahead of common shareholders in dividend payments and bankruptcy.

Preferred stocks are far more complicated than common stocks. They allow for different treatments, such as converting from bonds to stocks. Preferreds carry different rules, and even experienced investors are unfamiliar with this security style.

How to Invest In Securities

All publicly traded securities listed 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.

bonds

With the advent of electronic online trading, 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 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.

Investors can exchange the assets in the secondary market for cash or capital gain. The secondary market is not as liquid as the primary market and is 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 raising money or liquidity for an entity such as a city, company, or 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 SEC (U.S. Securities and Exchange Commission) handles The regulation of securities in the U.S., which handles all the regulations of a public offering and sales of securities.

Any public offerings, sales, and securities trades must file and register with SEC’s state securities departments. FINRA (Financial Industry Regulatory Authority) regulates state security departments.

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 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.

different types of securities

Staring in 1928 to 2020

S&P 500

3-month T-Bill

U.S T Bond

Baa Corporate Bond

Returns

9.9%

3.35%

5%

7.06

Now, let’s put the same idea through the last fifty years.

S&P 500

3-month T-Bill

U.S. T Bond

Baa Corporate Bond

Returns

10.8%

4.46%

6.9%

9.28%

And finally, let’s look at the returns over the last ten years.

S&P 500

3-month T-Bill

U.S. T Bond

Baa Corporate Bond

Returns

13.77%

0.51%

4.41%

7.26%

The above charts offer an interesting data set, and we can see that equity securities over approximately one hundred years offer a darn good return. But bonds over the last fifty remain nothing to sneeze at either, especially with the nature of conservatism.

Investor Takeaway

As an investor understanding the basics of our investments 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 juice their returns, but it remains a more risky strategy outside my comfort zone. I don’t partake in 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 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; we have a few ideas around that subject.

To Warren Buffett, the risk remained the permanent loss of capital, i.e., bankruptcy. Avoiding permanent losses remains one of the sure ways to ensure you will do well in the market over the long run.

To others, the risk remains the risk of your investment’s price falling, which remains almost impossible to ignore if you invest for a long period. We will have market drawdowns, such as in March 2020, but staying logical and in the market remains the way.

Bonds offer more safety, albeit with lower returns. The bond market is far less sexy and not followed by most investors. But for some, using bonds helps them invest for their goals.

Knowing and understanding the different securities will help in that goal, whichever way you decide to go in investing.

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 further assist, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave

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