Stocks and Bonds

  • Grades: 3–5, 6–8

Much of the world's business activity would be impossible without stocks and bonds. Stocks and bonds are certificates that are sold to raise money for starting a new company or for expanding an existing company. Stocks and bonds are also called securities, and people who buy them are called investors.

Stocks

Stocks are certificates of ownership. A person who buys stock in a company becomes one of the company's owners. As an owner, the stockholder is eligible to receive a dividend, or share of the company's profits. The amount of this dividend may change from year to year depending on the company's performance. Well-established companies try to pay stockholders as high a dividend as possible.

There are two types of stock: common stock and preferred stock. Owners of common stock may vote for company directors and attend annual stockholders' meetings. At these meetings they have the chance to review the company's yearly performance and its future plans, and to present their own ideas. Owners of preferred stock do not usually have voting rights or the right to attend stockholders' meetings. They do, however, have priority when dividends are paid. The dividends on preferred stocks are paid according to a set rate, while the dividends on common stocks fluctuate according to the company's performance. If the company does well, however, preferred stocks do not usually gain in value as much as common stocks. If a company goes out of business, preferred stockholders are paid off first.

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Bonds

Bonds are certificates that promise to pay a fixed rate of interest. A person who buys a bond is not buying ownership in a company but is lending the company money. The bond is the company's promise to repay that money at the end of a certain time, such as ten, fifteen, or twenty years. In return for lending the company money, the bondholder is paid interest at regular intervals. The interest rate is based on general interest rates in effect at the time the bonds are issued, as well as on the company's financial strength. Bonds generally pay more money than preferred stocks do, and they are usually considered a safer investment. If a company goes bankrupt, bondholders are paid before both preferred and common stockholders.

Local, state, and national governments also issue bonds to help pay for various projects, such as roads or schools. The interest the bondholder receives from state and local bondsalso called municipal bondsis usually exempt from taxes.

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History of Stocks and Bonds

The trading of goods began in the earliest civilizations. Early merchants combined their money to outfit ships and caravans to take goods to faraway countries. Some of these merchants organized into trading groups. For thousands of years, trade was conducted either by these groups or by individual traders.

During the Middle Ages, merchants began to gather at annual town fairs where goods from many countries were displayed and traded. Some of these fairs became permanent, year-round events. With merchants from many countries trading at these fairs, it became necessary to establish a money exchange, or bourse, to handle financial transactions. (Bourse is a French word meaning "purse.")

One important annual fair took place in the city of Antwerp, in present-day Belgium. By the end of the 1400's, this city had become a center for international trade. A variety of financial activities took place there. Many merchants speculatedthat is, they bought goods for certain prices and hoped that the prices would rise later so they could make profits when they sold the goods. Wealthy merchants or moneylenders also lent money at high rates of interest to people who needed to borrow it. They then sold bonds backed by these loans and paid interest to the people who bought them.

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The Beginning of Modern Stocks

The real history of modern-day stocks began in Amsterdam in the 1600's. In 1602, the Dutch East India Company was formed there. This company, which was made up of merchants competing for trade in Asia, was given power to take full control of the spice trade. To raise money, the company sold shares of stock and paid dividends on them. In 1611 the Amsterdam Stock Exchange was set up, and trading in Dutch East India Company shares was the main activity there for many years.

Similar companies were soon established in other countries. The excitement over these new companies made many investors foolhardy. They bought shares in any company that came on the market, and few bothered to investigate the companies in which they were investing. The result was financial instability. In 1720, financial panic struck in France when, after a rush of buying and selling, stockholders became frightened and tried to sell their stocks. With everyone trying to sell and no one buying, the market crashed.

In England, a financial scandal known as the South Sea Bubble took place a few months later. The South Sea Company had been set up in 1710 to trade with Spanish South America. The proposed size of company profits was exaggerated, and the value of its stocks rose very high. These high stock prices encouraged the formation of other companies, many of which promoted farfetched schemes. In September 1720, South Sea stockholders lost faith in the company and began to sell their shares. Stockholders of other companies began to do the same, and the market crashed as it had in France. These companies became known as "bubble companies" because their stock was often as empty and worthless as a bubble and the companies collapsed like burst bubbles.

Even though the fall of bubble companies made investors wary, investing had become an established idea. The French stock market, the Paris Bourse, was set up in 1724, and the English stock market was established in 1773. In the 1800's, the rapid industrial growth that accompanied the Industrial Revolution helped stimulate stock markets everywhere. By investing in new companies or inventions, some people made and lost huge fortunes.

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Rise of the Small Investor

For many years, the main buying and selling of stocks was done by a few wealthy individuals. It was not until after World War I that increasing numbers of small investors began to invest in the stock market. There was a huge rise in speculative stock trading during the 1920's, and many people made fortunes. However, the Roaring Twenties came to an abrupt end in October 1929, when stock markets crashed and fortunes were wiped out overnight. The crash was followed by the Great Depression of the 1930's, a period of severe economic crisis throughout much of the world.

Since the end of World War II, small investors have begun investing again in stocks, and stock markets have been relatively stable. A sharp fall in prices in 1987 led to another stock market crash. Initially, this frightened many people away from stock investments. But within a few months the market recovered and investor confidence returned.

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Stock Exchanges Today

Today, the largest and most important stock exchanges are the New York Stock Exchange, the London Stock Exchange, and the Tokyo Stock Exchange. These exchanges act as marketplaces for the buying and selling of stocks. Another important source of stock transactions is the NASDAQ system. NASDAQ, which stands for National Association of Securities Dealers Automated Quotations, allows stock transactions to be made over computer terminals simultaneously in many cities around the world. Thousands of stocks are now traded over the NASDAQ system.

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The New York Stock Exchange

In colonial America there were no stock exchanges. People who wanted to buy and sell securities met in auction rooms, coffeehouses, or even on street corners. Stock trading was unorganized, and people were reluctant to invest because they could not be sure they would be able to resell their securities.

In 1792, a small group of merchants made a pact that became known as the Buttonwood Tree Agreement. These men decided to meet daily to buy and sell stocks and bonds. This was the origin of America's first organized stock market, the New York Stock Exchange (NYSE).

Today there are more than 1,000 members of the New York Stock Exchange. Each of these members "owns a seat" on the exchange. This term comes from early years, when members had to stay seated while the exchange's president called out the list of securities to be traded. Despite the change and growth of the New York Stock Exchange over the years, its basic purpose has remained much the sameto allow companies to raise money and to allow the public to invest and make their money grow.

The New York Stock Exchange operates under a constitution and a set of rules that govern the conduct of members and the handling of transactions. The members elect a board of directors that decides policies and handles any discipline problems. The exchange is controlled by its own rules and by federal regulations set up by the Securities and Exchange Commission, which was established by the U.S. government in 1934 under the Securities and Exchange Act.

Until 1869 it was easy for a company to have its securities listed on the exchange. A broker simply had to propose that a certain security be traded and get the consent of a majority of the other members. As business expanded, however, greater regulation became necessary, and the exchange established its first requirement for listing a companythat it be notified of all stock issued and valid for trading. In the years that followed, the exchange added more requirements, including company reports on earnings and other financial information. This helps potential investors make investment decisions more wisely.

To qualify for a listing on the exchange today, a company must be in operation and have substantial assets and earning power. The exchange considers a company's permanence and position in its industry as well. All common stocks listed on the exchange must have voting power, and companies must issue important news in such a way that all investors have equal and prompt access to it.

In addition to the New York Stock Exchange, which is the largest exchange in the United States, investors can also buy and sell stocks on the American Stock Exchange and several regional exchanges. The American Stock Exchange, also located in New York, trades stocks of small and medium-sized companies that do not meet the requirements for listing on the NYSE. Regional exchanges in Boston, Philadelphia, San Francisco, and other U.S. cities handle stocks listed on the NYSE as well as local securities.

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How the Stock Exchange Works

The New York Stock Exchange itself neither buys, sells, nor sets prices of any securities that are listed. It simply provides the marketplace in which stocks and bonds are bought and sold.

Placing an Order. Suppose an investor in Iowa decides to buy 2,000 shares of XYZ Corporation. The investor calls a stockbrokera registered representative of a stock exchange memberwhose job is to provide investors with information and carry out investors' orders to buy and sell. The investor asks the broker the price of XYZ stock. The broker checks the price on a computer terminal and learns that XYZ Corporation is quoted at 25 to a quarter. This means that, at the moment, the highest bid to buy XYZ is $25 a share and the lowest offer to sell is $25.25 a share. The investor tells the broker to buy "at the market," which means to buy shares at the best available price at the time the order reaches the stock exchange. If the investor sets an exact price he or she is willing to pay, the order is called a "limit order," and no sale can take place unless another stockholder wants to buy or sell at that price.

By telephone or computer, the broker in Iowa sends the investor's order through a trading desk at his or her firm's main office to a clerk on the floor of the stock exchange in New York. The clerk alerts the firm's floor broker by putting the broker's call number on two boards, one on each side of the trading floor. These boards are visible no matter where the floor broker is standing. The broker sees the call number and immediately goes to take the order.

Trading Stock. Small orders, such as those under 1,000 shares, often are executed automatically by computer at the best possible price at the time. Larger orders, however, are traded on the floor of the exchange, with a floor broker bargaining on the investor's behalf. This is the case with the Iowa investor's order of 2,000 shares of XYZ Corporation stock.

After receiving the order, the floor broker hurries to the place, called the trading post, where XYZ Corporation shares are traded. Other brokers with orders to buy or sell stocks will also be gathered there. Each trading post handles about 85 different stocks. This is where the exchange's member-brokers make transactions for investors.

At the trading post, the floor broker looks up at a video monitor above the post to see the current buy and sell prices for XYZ stock. Or he asks loudly, "How's XYZ?" and a specialist in that stock answers, "Twenty-five to a quarter." This means that the order could be filled immediately at a price of 25 [frac14], or $25.25. It is the broker's job, however, to get the best possible price for an investor. he broker believes that a bid of 25 [frac18]will be accepted, so he loudly makes that bid. Another broker who has an order to sell 2,000 shares of XYZ at 25[frac18] accepts the bid and says, "Sold." A trade has taken place at 25[frac18].

Completing a Trade. Each broker completes the agreement by writing the price and the name of the other broker's firm on an order slip. The brokers report the transaction to their telephone clerks, so that the investors can be notified. Meanwhile, a record of the transaction is entered into the exchange's huge computer. This allows the transaction to be displayed, with all others, on thousands of computer terminals throughout the United States and around the world.

Specialists. Specialists are stock exchange members who help maintain an orderly market in the stocks for which they are registered. They do this by buying and selling for their own accounts whenever there is a temporary gap between supply and demand. In this way, they smooth the way for investors, allowing them to sell when there are few buyers or to buy when there are few sellers.

Specialists also act as brokers. A floor broker may choose to leave an order with a specialist, to be carried out when the stock reaches a certain price. Specialists are especially helpful with limit orders (orders with set prices). The price on a limit order may not come up for a week or longer, or not at all. It would be impractical for a floor broker to wait until a matching bid was made.

Odd Lots. Although a few stocks are sold in lots of 10 shares, most are sold in lots of 100. Many people, however, may want to buy only a few shares of stock rather than a complete lot. Shares sold in lots other than 10 or 100 are called odd lots. Orders in odd lots are not matched against other orders. They are carried out by specialists or by brokerage firms for their own accounts. The odd-lot system makes it possible for people with limited incomes to invest in the stock market.

Buying on Margin. Sometimes investors may wish to buy stocks but would prefer not to pay the total market price at the time of purchase. In such cases, the investors may buy on marginthat is, they pay only part of the price (usually at least half) when the stocks are purchased, and get credit for the rest from the brokerage firm. Buying on margin is very risky because the loan must be repaid to the broker, with interest, even if the price of the stock falls. To protect buyers and sellers, therefore, the federal government and the stock exchange regulate the buying of stocks on margin.

Bulls and Bears. Bulls and bears refer to investors. A bull is someone who believes the market will rise; a bear anticipates a market decline. Bulls and bears buy or sell hoping that the market will follow the pattern they predict. As optimists, bulls generally buy stocks expecting the value to rise, at which point they can sell and make a profit. As pessimists, bears sell stocks at a high price because they anticipate a market decline.

Selling Short. Investors who can satisfy certain securities regulations may sell short, or sell shares of stock they do not actually own. In selling short, an investor borrows shares from a broker who is willing to lend stock. The investor finds a buyer for the stock at the current market price, and then hopes that the price drops. When the price drops low enough, the investor buys the shares needed to complete the short sale and returns the borrowed shares to the lender. Selling short is risky. If the price drops, investors can make a profit on the difference between the high selling price and the low buying price. But if the price does not drop as expected, the investor not only does not make a profit, but can lose money buying shares at a higher price in order to return them to the lender.

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Making Investments

Before investing money in securities, people should have a basic financial plan and understand the risks as well as the rewards of investing. Investors should make certain that, in addition to their regular income, they have money set aside for personal emergencies. Investments often require time to increase in value. A careful study of the products, financial histories, and future plans of companies can help investors choose stocks that will allow their wealth to grow over time. Investors who prefer less risk might consider a money market fund where their original investment is safe and earns current rates of interest.

Many investors today choose to invest in mutual fundspools of money (from thousands of investors) that are invested in a variety of stocks or bonds by professional managers. By having a professional buy and sell for them, investors benefit from that person's expertise and constant monitoring of the portfolio. In addition, a mutual fund offers a diversified group of stocks or bonds, which means that a single investor can own pieces of many companies with a relatively small monetary investment. Such diversification also means that fund shareholders, unlike owners of individual stocks, are at less risk when a single stock drops sharply in value. Because of these desirable features, mutual funds have become a popular investment alternative for many investors.

Jordan E. Goodman
Senior Reporter, Money; Coauthor, Barron's Dictionary of Finance and Investment Terms

  • Subjects:
    Money, Real-World Math, Entrepreneurship, Markets and Trade
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