Evaluating Popular Investments Lesson 1 Stock vs. Bonds as Investments

Investing in Stocks vs Bonds Aim:  What are the pros and cons of investing in stocks vs. bonds? Do Now:  Explain from the corporation’s perspective why issuing bonds is riskier than stock.

 Do Now answer: 1.The borrowed money must be paid back 2.The company is obligated to pay interest to the bond holdholders each year Investing in Stocks vs Bonds

Review: What am I, a share of common stock or a bond? 1.I come with one vote per unit 2.Those who own me are entitled to receive interest payments twice per year 3.At the end of my term I am turned in for what the investor paid for me 4.If the corporation goes out of business, my owners get in line first to receive cash from the liquidation of assets 5.If the corporation didn’t earn enough profit, it may not pay dividends to my owners

In a moment, we’ll review the pros and cons of stocks and bonds from the investor’s standpoint. Before we do, we should cokeep in mind that the “flip side” to the investor is the company.  Example: The right to collect interest on bonds is a pro to the investor, but the obligation to pay it is a con to the company! Investing in Stocks vs Bonds

For the investor… UpsideDownside Owning stock May make a lot of money!Not entitled to receive dividends; may lose everything if company fails Owning bonds Entitled to regular payments and money back at maturity; will receive some money back if company fails What can be earned is limited

Investor S buys 10 shares of stock in a ABC Company. The share price is $100, so he has invested $1,000 in total. The company is in the habit of paying a $5 per share per year in dividends.  Doing a little math, we see that Investor S is receiving $5 * 10 shares = $50 per year in dividends. Investing in Stocks vs Bonds

Investor B owns one ABC Company $1,000 bond that pays 5% interest. 5% of $1,000 is $50. Investor B is also receiving $50 per year. It seems like they are in the same situation. They are both investors in ABC Company and they each receive $50 per year from the company. Investing in Stocks vs Bonds

Scenario: The economy sinks into a recession. ABC Company’s sales fall and it is now barely making any profit. Knowing that dividends are a payout of excess profits and that there are no longer any excess profits, ABC announces that it’s cutting the dividend to $1 per share! Investing in Stocks vs Bonds

Now, who’s in a better position?  Answer: Investor B is still receiving $50 per year. Investor S is only getting $1 * 10 shares, or $10 per year. Investor B! Why wasn’t Investor B impacted?  Answer: The Company is not permitted to cut the interest payments. It is legally obligated to pay the interest. Shareholders suffer first! Investing in Stocks vs Bonds

The second reason that bonds are safer is that Investor B will be paid back the $1,000 he invested.  Scenario: With the recession, the share price of ABC Company drops to $65.  Investor S pulls out a calculator. $65 per share * 10 shares = $650. He bought the shares for $1,000! If he sells his shares to another investor, he’ll suffer a $350 loss!  Again, Investor B is in a safer position! Investing in Stocks vs Bonds

We have to ask the question: Why do people buy stock if it’s so risky?  Answer: Even though there is significant risk, there’s also the chance to make a lot of money.  Because there is no upper limit on a company’s stock price, there is no limit to how much an investor can make.  Example: Google stock rose over 12 times its original value in the first 10 years after it went public! Investing in Stocks vs Bonds

Lesson Summary 1.Why is investing in bonds safer than investing in stock? 2.What can cause a company to cut its dividend as well as its stock price to fall? 3.What is the maximum amount of money a stock investor can make? 4.What are the pros and cons of investing in stocks vs. bonds?

Web Challenge #1 Q: The Great Recession was caused in part by banks that made questionable loans and investments that they would not be able to collect. What is one method of shoring up the finances of any company in financial trouble? A: Stop paying dividends! Challenge: Research banks that cut their dividends during the Great Recession. What was their original dividend and the revised one? How many years passed until they were able to begin increasing it?

Web Challenge #2 Stocks can be very volatile. Their price can shoot up or drop dramatically when a good or bad event occurs.  Challenge: To illustrate the risk stock investors take, research three well-known stocks that have fallen dramatically in a single day. (Hint: Include the term “plunges” in your search phrase). What companies fell, by what percentage and for what reason?

Web Challenge #3 A benefit that shareholders is a vote for each common share they own. However, unless an investor has billions of dollars to throw around, the number of shares (and votes) an investor has are unlikely to be very influential.  Challenge: Research large investors to who buy ownership in companies to effect change. Find three companies targeted by these “activist investors” and described the changes they seek. (Hint: See what Bill Ackman and Daniel Loeb are up to).