Are you thinking about investing in securities? Investment securities (also known as “security investments” or just “securities”) offer greater opportunities to grow your money than bank savings accounts. But securities also carry greater risk than traditional savings accounts. Understanding what a security is and the different types of investment securities available are critical first steps toward determining which investments are right for you.
What Is a Security?
A "security" (or "investment security") is a broad term used for a financial asset with monetary value that's created from an initial investment. Typically, securities can be traded, but this isn't necessary.
Black's Law Dictionary, a commonly used legal dictionary, defines a "security" as an instrument that represents the instrument holder's:
- ownership rights in a firm (like a stock)
- creditor relationship with a firm or government (for example, a bond), or
- other rights (such as an option).
For example, you might invest money in a new corporation in exchange for stock (ownership in the company). Or, you might purchase a bond for a bank to redeem later, hopefully at a higher price than what you initially paid.
The Howey Test: What Qualifies as a Security?
The term "security" can apply to a wide range of investments, such as stocks, bonds, and options. These types of securities are usually readily identifiable and widely accepted. But what's considered a security can be difficult to ascertain under more unique circumstances, such as investing in digital assets. In these cases, it's best to figure out what's considered an "investment contract" under the Howey Test.
The Securities Act of 1933— and many other securities laws— defines "securities" as including investment contracts. The Supreme Court established the Howey Test in 1946 to define what's considered an "investment contract." If something is classified as an investment contract, then it's considered a "security" and must follow securities laws.
If an investment meets this four-part test, then it's classified as a security:
- Money is invested.
- The investment is part of a common enterprise.
- The investors expect the enterprise to profit.
- Any profit is a result of the efforts of others.
(SEC v. Howey Co., 328 U.S. 293 (1946).)
In other words, if you invest money in a venture that you expect to make a profit and that profit is dependent on other people's efforts, then your investment is a security.
U.S. Securities Laws
If you're an issuer or holder of a security, you must follow federal and state securities laws. While many laws cover securities, the main federal laws to be aware of are the following:
- Securities Act of 1933
- Securities Exchange Act of 1934
- Trust Indenture Act of 1939
- Investment Company Act of 1940
- Investment Advisers Act of 1940
- Sarbanes-Oxley Act of 2002
- Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and
- Jumpstart Our Business Startups Act of 2012.
Most of these securities regulations were put into place after financial disasters, namely, the stock market crash of 1929 and the economic recession in the late 2000s. The U.S. Securities and Exchange Commission (SEC) is a federal agency created by the Securities Exchange Act to create and enforce rules around securities.
Types of Investment Securities
There are various types of investment securities. Three of the most common securities are:
- equity securities (stocks)
- debt securities (bonds), and
- derivative securities.
Let's take a closer look at these different kinds of securities.
Equity Securities: Stocks
The ownership of a corporation is made up of shares of stock. When you buy a share, you're buying an ownership interest in the company.
Shares of publicly traded companies are bought and sold on various stock exchanges (most prominently, the New York Stock Exchange and NASDAQ). These exchanges collectively make up what we call the “stock market.”
When you invest in stocks, you're investing either in individual companies or in mutual funds that own shares of multiple companies. (We cover mutual funds later.)
Common Stock vs. Preferred Stock
Most stock is what’s known as “common stock.” Most individual investors in the stock market own common stock. Owners of common stock (called "shareholders") can vote on company matters and will receive dividends (payouts) on a pro rata basis according to the number of shares they own.
A second type of stock, “preferred stock,” gives the shareholder greater rights than common stock. Those rights include the right to dividend income and to return of capital if the company is liquidated. Individual investors aren’t likely to own preferred shares in a public company, but they can invest in mutual funds that invest in preferred stock.
Making Money on Stocks
You can make money on a stock in two ways:
- by selling your shares at a higher price than you paid, and
- through dividends.
Trading Stock: “Buy Low, Sell High”
Suppose you buy a stock at $10 per share and sell it later for $13 per share, you've made a profit of $3 per share. If you buy and sell 100 shares at these prices, you'll make a $300 profit on your initial $1,000 investment. That’s a nice 30% return on your money.
But stock prices can and do fluctuate. The stock that you bought for $10 per share might have dropped to $6 per share in the first year you own it, rebounded to $10 in the second year, and reached the $13 price only in the third year. In that case, you'll need to hold the stock for three years to earn that $300 profit. If you had sold during the first year because you needed the cash or lost faith in the stock after the decline, you would've sold at a loss.
If you invest in the stock market, understand that it’s not always possible to buy low and sell high, and that you could lose money on the stocks you buy. The stock that declined from $10 to $6 might never make it back to $10, or it might take a very long time to do so.
The good news is that while stocks can be a risky investment, historically, they've outperformed bonds (which we discuss below).
Before investing in stocks, think about how willing you are to risk losing money in order to have a chance at the greater upside potential of stocks. This willingness is known as your “risk tolerance.” Also, understand that the stock market tends to work best for long-term investors. The market can be very unkind to those looking for quick profits.
Income from Dividends
The other way to make money on stocks is through dividends. Dividends are distributions of cash or additional shares of stock to existing shareholders, usually but not always representing a sharing of the corporation’s profits.
“Dividend stocks” are stocks that make these distributions regularly, usually quarterly or annually. Dividends can provide a source of predictable income, and dividend stocks can be less volatile (less prone to major ups and downs in share price) than other stocks.
Debt Securities: Bonds
Bonds are debt securities. They’re similar to a loan from your bank. A bond, like a bank loan, has:
- a principal amount
- an interest rate, and
- a time period for repayment.
But as a bond investor, you’re the lender rather than the borrower. The borrower is a corporation or government entity that issues the bond (the “issuer” of the bond).
How Do Bonds Work?
Bonds are generally less risky than stocks, but they tend to provide lower returns. Less risk, less return.
When a bond matures (reaches its due date), you, as the owner of the bond (the bondholder), receive the principal (or face value) of the bond. Between the date you purchase the bond and the maturity date, you receive interest payments at the stated interest rate.
For example, suppose you purchase a $1,000, 5-year, 5% bond. You'd pay $1,000 at the outset. For the next five years, you'd receive interest payments of $50 ($1,000 x 5%). At the end of the fifth year, when the bond matures, you'll receive the final interest payment, plus repayment of the $1,000 principal amount of the bond.
The example above shows why bonds are often referred to as “fixed-income securities.” Your income is the interest, which is fixed at 5%. If you hold the bond to maturity, you receive income at 5% and the $1,000 principal amount is repaid in full.
Can you lose money on a bond? Yes, it’s possible to lose money on a bond investment, but it’s unlikely. In the example above, where you bought the bond when it was issued and held it for the full five years, your only risk of loss would be the issuer possibly defaulting on the bond. (We cover default risk for various types of bonds below.)
What Are the Main Types of Bonds?
There are many types of bonds. But, in general, there are three major types:
- Corporate bonds: Corporate bonds are issued by companies. These bonds are rated for risk by credit rating agencies and fall into two general categories: investment grade and below investment grade (also known as "junk bonds"). An investment-grade corporate bond is considered a safe investment, with little risk that the corporate issuer will default on the bond. Below investment-grade bonds carry a higher risk that the issuer will default. Interest rates on junk bonds are higher than investment-grade bonds to compensate investors for the additional default risk. Interest income on corporate bonds is fully taxable for state and federal income tax purposes.
- U.S. government bonds: U.S. government bonds are issued by the federal government to help finance the national debt. The most common government bonds are Treasury bonds. Government bonds have very low investment risk because they're guaranteed by the United States. But their potential return is lower than that for stocks and corporate bonds because of their lower associated interest rates. Interest income on U.S. Treasury bonds is exempt from state and local income taxes, but not federal income tax.
- Municipal bonds: Municipal bonds are debt securities from state and local government entities. These local entities include counties, cities, towns, and school districts. Interest income you earn on municipal bonds is usually exempt from federal income taxes. Your income might also be exempt from state and local income taxes if you live where the bonds are issued. However, the interest rate is usually lower than that for corporate bonds.
While these bonds are generally safer than stock investments, they still vary in their risk and return. You should keep these considerations in mind when determining where to invest.
Derivative Securities
A "derivative security" isn't a stock or bond itself. It’s a security that allows you to purchase or sell a stock or bond in the future, by a certain date and at a particular price. Stock options are perhaps the best-known type of derivative.
A "stock option" is the right to buy or sell a stock at a certain price for a period of time. In addition:
- a “call” is the right to buy the stock; and
- a “put” is the right to sell the stock.
For example, suppose a stock is currently trading at $30 per share. You think the price will go up in the next six months. You might purchase a six-month option to buy 100 shares at, say, $32. You purchase that option for $1.00 per share, for a total of $100.
The stock goes to $40 four months into the six-month period, and you decide to exercise your option. You purchase the shares at the option price of $32. You now own 100 shares that cost you $3,300 to acquire—$3,200 for the shares plus the $100 cost of the option. You could sell those 100 shares today for $40 per share—getting back $4,000 in total, for a profit of $700 ($4,000 minus $3,300).
A put option works in reverse to a call option. It gives you the right to sell a stock in the future at a certain price. This strategy limits your downside in the event a stock you own declines in value.
Derivatives are complicated and inherently risky. Think of them as wagers—but on the future price of a security rather than on the outcome of a sporting event. In each case, you’re trying to predict the future. Consult a financial professional if you’re curious about investing in derivatives.
Working With a Financial Advisor
Many people invest on their own. They understand financial instruments and markets, they do their homework, and they invest within their risk tolerance. Some pick their own stocks and bonds, while others pick mutual funds to invest in.
If you have questions about investing or want help in making investments, consider consulting a financial advisor. Friends and family might be able to refer you to their advisors, or you can look online. You won’t lack for choices, and you might find some good articles on picking a financial advisor who fits your needs.