The world of investing can seem mind-boggling for a beginning investor. How do you decide what type of security to invest in? Should you choose stocks, bonds or a combination of investments? What about mutual funds? How do you choose a particular fund, stock or bond? How do you assess the risk to your money?
This Financial Guide provides a starting point for inexperienced investors. It describes how securities markets work, what protections are afforded, the general types of securities available, the interaction of risk and reward and how to select the investments appropriate for your risk tolerance.
How Securities Are Bought and Sold
The term “securities” encompasses a broad range of investments, including stocks, corporate bonds, government bonds, mutual funds, options, and municipal bonds. Investment contracts, through which investors pool money into a common enterprise managed for profit by a third party, are also securities. Securities may be traded on an organized exchange or traded “over the counter” between investors.
Exchanges
Securities are bought and sold in a number of different markets. The best known are the New York Stock Exchange and the American Stock Exchange, both located in New York City. In addition, six regional exchanges are located in cities throughout the country.
A corporation’s securities may be traded on an exchange only after the issuing company has applied to the exchange and met any listing standards relating, for example, to the company’s assets, number of shares publicly held, and number of stockholders. Organized markets for other instruments, including standardized options, impose similar restrictions. The exchanges facilitate a liquid market for securities where buyers and sellers are brought together. Listing on an exchange, however, does not constitute approval of the securities or provide any assurance as to risk and return.
Over-The-Counter
Many securities are not traded on an exchange but are traded over the counter (OTC) through a large network of securities brokers and dealers. In the National Association of Securities Dealers’ Automated Quotation System (NASDAQ), which is run by the Financial Industry Regulatory Authority (FINRA), trading in OTC stocks is done via on-line computer listings of bid, which asks prices and completes transactions.
Like the exchanges, NASDAQ has listing standards that must be met for securities to be traded in that market. Similar to an exchange it provides a “meeting place” for buyers and sellers. The typical investor generally will not know whether their security is bought or sold through an exchange or over the counter. The investor engages a broker who arranges the transaction in the appropriate market at the desired price.
Brokers
If you buy or sell securities on an exchange or over the counter, you will probably use a broker, and your direct contact will be with a registered representative. The registered representative often called an account executive or financial consultant, must be registered with FINRA, a self-regulatory organization whose operations are overseen by the Securities and Exchange Commission (SEC), and with the states in which the broker is conducting business. The registered representative is the link between the investor and the traders and dealers who actually buy and sell securities on the floor of the exchange or elsewhere.
How Prices are Established
How are the stock prices that appear in the financial section of the newspaper arrived at? Market prices for stocks traded over the counter and for those traded on exchanges are established in somewhat different ways.
Exchange Prices
The exchanges centralize trading in each security at one location, on the floor of the exchange. There, auction principles of trading set the market price of a security according to current buying and selling interests. If such interests do not balance, designated floor members known as specialists are expected to step in to buy or sell for their own account, to a reasonable degree, as necessary to maintain an orderly market.
Over the Counter (OTC)
In the OTC market, brokers acting on behalf of their customers (the investors) contact a brokerage firm which holds itself out as a market-maker in the specific security, and negotiates the most favorable purchase or sale price. Commissions received by brokers are then added to the purchase price or deducted from the sale price to arrive at the net price to the customer.
In some cases, a customer’s brokerage firm may itself act as a dealer, either selling a security to a customer from its own inventory or buying it from the customer. In such cases, the broker hopes to make a profit on the purchase and sale of the security, but no commission is charged. Instead, a retail “mark-up” is added to the price charged by the firm when a customer buys securities and a “mark down” is deducted from the price paid by the firm when a customer sells securities.
Bid and Ask Prices
In both cases, a stock is quoted in terms of bid and ask. The bid is the price at which the market or market maker is willing to buy the security from you. Similarly, the ask is the price at which the market or market maker is willing to sell the security to you. Not surprising, the ask price is higher than the bid price. The difference between the two is called the spread. For example, if a stock is quoted 18-18 ¼, this means that the investor could sell the stock for $18 a share or purchase the stock for $18.25. The higher the spread the more the market maker profits and the higher the cost is to investors. Heavily traded securities typically have narrow spreads while infrequently traded securities can have wide spreads.
How Your Investments are Protected
Investors’ money is protected in three ways: by federal laws and regulations that are enforced by the SEC (Securities and Exchange Commission); by self-policing in the industry; and by state law.
Under federal securities laws, those engaged in the business of buying and selling securities have a great deal of responsibility for regulating their own behavior through SROs (self-regulatory organizations) operating under the oversight of the SEC. These SROs include all of the exchanges; the FINRA; the Municipal Securities Rulemaking Board (MSRB), which establishes rules that govern the buying and selling of securities offered by state and local governments; and other organizations concerned with somewhat less visible activities such as the processing of transactions.
The SROs are responsible for establishing rules governing trading and other activities, setting qualifications for securities industry professionals, regulating the conduct of their members, and disciplining those who fail to abide by their rules.
In addition, the federal securities laws provide investors with certain protections, including the ability to sue if they have been harmed as a result of certain violations of those laws.
Many brokerage firms require that their customers sign an agreement containing an arbitration clause when they open a brokerage account. If you sign an agreement with an arbitration clause, you are agreeing to settle any future disputes with the broker through binding arbitration, instead of through the courts.
Arbitration proceedings are administered by the SROs, and the rules that apply in arbitration proceedings are specified by each SRO. Although the SEC oversees the arbitration process, it cannot intervene on behalf of, or directly represent individual investors. Nor can the SEC modify or vacate an arbitration decision. The grounds for judicial review are very limited.
Further protection for investors is provided by state laws designed to regulate the sale of securities within state boundaries.
The Function of the SEC
The SEC, an independent agency of the U.S. Government, was established by Congress in 1934 to administer the federal securities laws. It is headed by five Commissioners, appointed by the President, who direct a staff of lawyers, accountants, financial analysts, and other professionals. The staff operates from its headquarters in Washington, D.C. and from five regional offices and six district offices in major financial centers throughout the country.
The SEC’s principal objectives are to ensure that the securities markets operate in a fair and orderly manner, that securities industry professionals deal fairly with their customers, and that corporations make public all material information about themselves so that investors can make informed investment decisions. The SEC accomplishes these goals by:
- Mandating that companies disclose material business and financial information;
- Overseeing the operations of the SROs;
- Adopting rules with which those involved in the purchase and sale of securities must comply; and
- Filing lawsuits or taking other enforcement action in cases where the law has been violated.
Despite the many protections provided by federal and state securities laws and SRO rules, it is important for investors to remember that they have the ultimate responsibility for their own protection. In particular, the SEC cannot guarantee the worth of any security. Investors must make their own judgments about the merits of an investment.
What Companies Must Disclose
Before any company offers its securities for sale to the general public (with certain exceptions), it must file with the SEC a registration statement and provide a “prospectus” to investors. In its registration statement, the company must provide all material information on the nature of its business, the company’s management, the type of security being offered and its relation to other securities the company may have on the market, and the company’s financial statements as audited by independent public accountants. A copy of a prospectus containing information about the company and the securities offered must be provided to investors upon or before their purchase. In addition, most companies must continue to update (quarterly and annually), in filings made with the SEC, this disclosure information to ensure an informed trading market.
The SEC reviews registration statements and periodic reports for completeness, but the SEC does not review every detail and verification of each statement of fact would be impossible. However, the securities laws do authorize the SEC to seek injunctives and other relief for registration statements containing materially false and misleading statements.
Persons who willfully violate the securities laws may also be subject to criminal action brought by the Department of Justice leading to imprisonment or criminal fines. The laws also provide that investors may be able to sue to recover losses in the purchase of a registered security if materially false or misleading statements were made in the prospectus or through oral solicitation. Investors must seek such recovery through the appropriate courts since the SEC has no power to collect or award damages or to represent individuals.
How the SEC Supervises Industry Professionals
Another important part of the SEC’s role is supervision of the securities markets and the conduct of securities professionals. The SEC serves as a watchdog to protect against fraud in the sale of securities, illegal sale practices, market manipulation, and other violations of investors’ trust by broker-dealers, investment advisers, and other securities professionals.
In general, individuals who buy and sell securities professionally must register with the appropriate SRO, meet certain qualification requirements, and comply with rules of conduct adopted by that SRO. The broker-dealer firms for which they work must, in turn, register with the SEC and comply with the agency’s rules relating to such matters as financial condition and supervision of individual account executives. In addition, broker-dealer firms must also comply with the rules of any exchange of which they are a member and, usually, with the rules of the FINRA.
The SEC can deny registration to securities firms and, in some cases, may impose sanctions against a firm and/or individuals in a firm for violation of federal securities laws (such as, manipulation of the market price of a stock, misappropriation of customer funds or securities, or other violations). The SEC polices the securities industry by conducting inspections and working in conjunction with the securities exchanges, the FINRA, and state securities commissions.
Protecting Yourself
You should be as careful about buying securities as you would be about any other costly purchase. The vast majority of securities professionals are honest, but misrepresentation and fraud do take place. Observe the following basic safeguards when “shopping” for investments:
- Never buy securities offered in unsolicited telephone calls or through “cold calls.” Ask for information in writing before you decide. Check on the credentials of anyone who tries to sell you securities.
Tip: Beware of salespeople who try to pressure you into acting immediately.
- Don’t buy on tips or rumors. Not only is it safer to get the facts first, but also it is illegal to buy or sell securities based on “inside information” which is not generally available to other investors.
- Get advice if you don’t understand something in a prospectus or a piece of sales literature.
Tip: Be sure you understand the risks involved in trading securities, especially options and those purchased on margin. Be skeptical of guarantees or promises of quick profits. There is no such thing, at least not without an accompanying increase in risk.
- Remember that prior success is no guarantee of future success in an investment arrangement.
- With tax-sheltered investments, partnerships, and other “liquid” investments be sure to ask about the liquidity and understand that there may not be a ready market when you want to sell.
- Don’t speculate. Speculation can be a useful investment tool for those who can understand and manage the risks involved and those who can afford to lose money, but it is dangerous for most people.
Tip: For the average investor, more conservative investment strategies are generally appropriate.
Professional guidance can be very helpful in developing a sound investment program.
Types of Investments
Two broad categories of securities are available to investors: equity securities, which represent ownership of a part of a company and debt securities, which represent a loan from the investor to a company or government entity. Within each of these types, there are a wide variety of specific investments. In addition, different types can be combined (e.g., through mutual funds) or even split apart to form derivative securities.
Each type has distinct characteristics plus advantages and disadvantages, depending on an investor’s needs and investment objectives. In this section, we provide an overview of the most common classes of investment securities.
Stocks
The type of equity securities with which most people are familiar is stock. When investors buy stock, they become owners of a “share” of a company’s assets. If a company is successful, the price that investors are willing to pay for its stock will often go up and shareholders who bought stock at a lower price then stand to make a profit. If a company does not do well, however, its stock may decrease in value and shareholders can lose money. The rise in the price of a stock is termed appreciation or “capital gain.” The stockholder is also entitled to dividends, which may be paid out from the company. Investors, therefore, have two sources of profit from stock investments, dividends, and appreciation. Some stocks pay out most of their earnings as dividends and may have little appreciation. These stocks are sometimes referred to as income stocks. Other stocks may pay out little or no dividend, preferring to reinvest earnings within the company. Since all of an investor’s potential earnings comes from appreciation these stocks are sometimes referred to as growth stocks. Stock prices are also subject to both general economic and industry-specific market factors. There is no guarantee of a return from investing in stocks and hence there is risk incurred in investing in this type of security.
As owners, shareholders generally have the right to vote on electing the board of directors and on certain other matters of particular significance to the company. Under the federal securities laws, most companies must send to shareholders a proxy statement providing information on the business experience and compensation of nominees to the board of directors and on any other matter submitted for shareholder vote. This information is required so that stockholders can make an informed decision on whether to elect the nominees or on how to vote on matters submitted for their consideration.
Stock investments are typically common stock, which is the basic ownership share of a company. Some companies also offer preferred stock, which is another class of stock. Preferred stock typically offers some set rate of return (although it is still not guaranteed), and pays dividends before dividends are paid for common stock. Preferred stock may not, however, participate in as much upside as common stock. If a company does really well, preferred stockholders may receive the same dividend as any other year while common stockholders reap the rewards of a great year.
Corporate Bonds
The most common form of corporate debt security is the bond. A bond is a certificate promising to repay, no later than a specified date, a sum of money which the investor or bondholder has loaned to the company. In return for the use of the money, the company also agrees to pay bondholders a certain amount of “interest” each year, which is usually a percentage of the amount loaned.
Since bondholders are not owners of the company, they do not share in dividend payments or vote on company matters. The return on their investment is not usually dependent upon how successful the company is. Bondholders are entitled to receive the amount of interest originally agreed upon, as well as a return of the principal amount of the bond if they hold the bond for the time period specified.
Companies offering bonds to the public must file with the SEC a registration statement, including a prospectus containing information about the company and the security.
