Stocks, bonds, and other swear words
you were too embarrassed to ask about
By Don Eberley
"There is no such thing as a silly question."
- Unknown
It was sometime early in the Apollo moon landing era that I shocked my parents one morning with my first four-letter swear word. Actually my father wasn't so much "shocked" as "crippled with laughter". I was three years old at the time.
Naturally I had no idea what the word meant, at least not until I was older. Much older. I suppose I could have asked someone, but as time went by it just became too embarrassing. For years, I avoided schoolyard conversations in which my knowledge of the word might be tested.
Do you shy away from financial conversations because your knowledge might be tested? Do you carry around the burden of unanswered money questions that are embarrassingly basic to ask? If so, then this article is for you. Just close the blinds, lock the door, and read on.
Q: What is a stock?
A stock is one unit of ownership of a business. It is also called a "share".
If you own shares of Coca Cola then you are a part owner of that company. You are entitled to vote at shareholder meetings (which probably doesn't interest you), and to receive a dividend cheque in the mail four times a year (which probably does interest you).
In the old days stocks were issued as paper certificates which you could physically hold in your hands. Today you would have to print a screen shot of your stock portfolio and physically hold that in your hands, although I have no idea why anyone would want to.
Q: What is a dividend?
A dividend is a periodic cheque sent to you by a company whose stocks you own. It is your rightful share of the company's operating profit.
The nice thing about dividends is the way they get bigger and bigger, assuming you invested in a successful company as opposed to the other kind. An investor who bought $1,000 worth of Coca Cola shares way back in the 1960s, for example, has seen his dividends rise from about $15 per year to over $1,000 per year. That is not a typo. And there is no end to these increases in sight, as Coke keeps raising its prices and expanding its product lines.
Not all stocks pay dividends. If a company has no profit, or if the directors decide to use the profit to expand the business, then the shareholders must wait for their reward. But they won't wait forever. If the directors don't eventually produce a dividend, it's only a matter of time before the shareholders will vote for large men to show up on their doorstep.
Q: I own mutual funds but have never seen a dividend before. Where are they?
In a mutual fund dividends are typically reinvested automatically. So instead of seeing the income you get a higher unit price over time. In the long run, reinvested dividends may account for more than half of the growth of an equity fund.
Q: If a company is doing well and its dividend keeps going up, why does the stock rise and fall?
Stocks do not follow the direction of their underlying business like a freight car following a locomotive. More like a rubber ball on a 200-foot bungee cord following a locomotive.
This is because stock prices are not set by cool-headed accountants with calculators. They are negotiated "on the fly" between buyers and sellers, through frenetic trading floors where everybody eats a lot of sugar and drives a BMW. Depending on the mood of these various players, a stock can be held down below its fair value, or propelled way ahead of itself. But periods of irrational pricing never last forever. Eventually reality kicks in, and things return to normal for a few billionths of a second.
Smart investors learn to ignore the bouncing ball, and keep their eye on the train instead. When I compare Coca Cola's bouncing stock to its smooth-as-glass rising dividend, I know which one I prefer.
Q: When I buy a stock, how does the company make money?
It doesn't. When you become the owner of a company it is the previous owner who gets the money, not the company itself. The only exception is when a stock is first sold as a new issue. In that case the company is the one raising money, by selling off pieces of itself. But every subsequent transaction on the stock exchange is a simple change of ownership.
Q: How are bonds different from stocks?
Whereas a stock is a permanent ownership paper, a bond is a temporary I.O.U. It is a promise by a company to repay money that was previously lent to it, on a specific day and with a specific amount of interest. Once the bond is repaid the relationship is over.
Bonds are commonly seen as "safe" investments, but keep in mind that the real return after taxes and inflation is often negative. Stockholders take great pleasure in pointing this out, to which bondholders inevitably reply that it's better than losing one's shirt. The taunting usually goes back and forth like this until somebody ends up in tears.
Q: Are mutual funds more like stocks or more like bonds?
A mutual fund is not an individual investment like a stock or bond. It is a portfolio of investments which may include stocks and bonds. A single mutual fund can be considered a diversified portfolio on its own.
Think of stocks and bonds as flour and eggs, and mutual funds as a mixing bowl. I don't know if this makes things any clearer, but I guarantee that if you repeat it to your nosey neighbour next time he asks about your portfolio he will never bother you again.
Q: Every year I put money in my RRSP, but is this really the best place for it?
Because the main function of an RRSP is to defer the payment of income tax into the future, it is the best place for your money if you have a high income today and expect to earn much less in the future. ie: If you have a high-paying job with no pension plan.
If you're in a lower tax bracket, or expect your income to remain fairly high in retirement because of a pension, then the benefits of using an RRSP are debatable. You might be better off using a TFSA, to minimize future taxes and preserve Old Age Security benefits. For more information click here, or contact me for a private consultation.
Do you have a basic investment question that you're too embarrassed to ask? Send it to me privately at don@doneberley.ca. I'll be happy to answer it, and will try to watch my language.
DE