By JP Krahel
After last week’s explosive investing discussion (“Saving a little today will create cushy nest egg for tomorrow,” The Rider News, 11/16/07) our intrepid hero promptly called his dad’s broker and said, “Put all my money in an IRA and double it by next year!” Said hero now waits in your dorm’s trash room for discarded pizza boxes.
I’ve a tendency to exaggerate. Needless to say, it’s not a good idea to get your money involved in something you don’t understand well. If you’re interested in wagering your money on a few educated guesses, risking a total loss and hoping for a healthy return, read on.
There are two typical methods for the small investor (e.g., you) to put money down on a company: stocks and bonds. I’m sure you’ve heard both terms, and neither are as complicated as they seem. We’ll start with bonds.
If a company needs money, it can choose to issue bonds, which essentially means that they’re asking for loans from investors, as opposed to banks. If you buy a bond from a company, you’re getting a promise that the company will pay you your money back at the end of a specified time period, and that they’ll pay you interest on your investment every so often. A 10-year $1,000 bond paying 5 percent annual interest will get you payments of $50 per year for 10 years, followed by a return of your $1,000 at the end of that time.
Of course, the company has to survive long enough to pay you back. If you lent that grand to a company that goes bankrupt tomorrow, your odds of collecting your principal are, shall we say … slim. How do you know your risk of losing everything on a bond? Fortunately, organizations like Moody’s and Standard & Poor’s actually give grades to the bonds of different companies, all the way from AAA (nearly risk-free) to D (significant risk). Now, a company with a D rating will have to pay a much higher interest rate than one with, say, a BB rating, in order to entice you to take such a huge risk on it.
Stocks are a different ball game. A company can make the decision to “go public,” meaning that it sells shares on an open market, like the New York Stock Exchange. What are shares? A share is a fractional ownership of a company. To illustrate, at the end of 2006, Johnson & Johnson had around 243 million shares outstanding. If you owned one of those shares, you’d own 1/243,000,0000th of J&J. Unfortunately, owning a share of its stock doesn’t entitle you to free baby wipes. What you are entitled to is a small percentage of the company’s future earnings.
To put it simply, a company’s stock price is determined by how well the company is expected to do in the future.
As happens all too often, it seems I’m out of space before I’m out of things to say. Many people have made a lot of money on these kinds of investments; many more have, to put it plainly, not done so well. The best defense is education.
If you’d seriously like to supplement your income with what essentially amounts to legalized gambling, sign up for a basic accounting or finance course. Few things are as empowering or rewarding as wise investments and understanding, believe me.