Stocks Broken Down
Stocks are one of the three pillars of traditional investment portfolios, alongside bonds, cash, and cash equivalents. Compared to these asset classes, stocks are attractive to investors because of their robust return potential, especially in today’s ultra-low interest rate environment. However, higher returns are often correlated with higher risks, especially in today’s volatile market.
Read on to learn more about the types of stocks, how stocks are traded, whether stocks are right for your portfolio, and some alternative investments that deliver comparable returns to stocks with significantly less risk, such as farmland.
Buying a stock (also known as a share) is a way for investors to purchase an ownership stake (equity) in a publicly traded company. When you buy shares, your equity stake is proportionate to the total number of shares outstanding. For example, if you own 100 shares of ABC Corp out of a total of 10,000 shares outstanding, you are a 1.0% owner of the company. Buying shares allows you to benefit from the company’s performance in the form of dividend payments and price appreciation of the stock.
Companies issue stocks in order to raise capital for any number of reasons, including expanding their business, repaying debt, or acquiring another company. Broadly speaking, corporations have two ways they can raise capital: debt or equity. The advantage of issuing equity is that companies are able to raise a lot of capital with fewer restrictions on their business, compared to those a bank lender or bondholder would impose.
Types of stock
Stocks fall into two main categories: common stock and preferred stock (prefs). These two instruments differ in several key respects, with prefs being more similar to bonds. Typically, prefs are issued with a fixed dividend payment, like a coupon on a bond. Dividends can be suspended but often accrue and are paid out as soon as possible. In a bankruptcy scenario, preferred shares rank above common shares but below corporate debt. Finally, preferred shareholders tend not to have voting rights.
In contrast, common shareholders receive dividend payments at the company’s discretion. If the company outperforms, dividends should increase, while underperformance usually leads to dividend payments being cut or suspended. Common stockholders are also able to vote on members of the Board of Directors or certain corporate policies, including issuance of additional shares or mergers and acquisitions.
Because of these different features and risk profiles, common stock appreciates much more than prefs, which tend to trade around their issuance price. This makes common stock riskier as well, as prices can plummet in the face of bad company news or market-wide disruptions. While there may be a place in your portfolio for preferred shares, when people talk about high returns in the stock market, they are thinking of common stock.
Trading stocks on the secondary market
Once a stock has been issued by a company, it can be bought and sold by investors on a stock exchange. The price of stocks on an exchange is impacted by several factors, some of which are within the company’s control and some of which are not. These include both the company’s current performance and expected future performance, as well as external events that impact the stock market as a whole, such as the coronavirus pandemic.
There are currently two major stock exchanges in the US: the New York Stock Exchange (NYSE) and the Nasdaq. Together, these exchanges have a combined market cap of over $33 trillion. In general, the Nasdaq attracts more tech and early-stage companies, while many of the companies listed on the NYSE tend to be mature, “blue chip” stocks. For example, Facebook, Amazon and Apple are all listed on the Nasdaq, while companies listed on the NYSE include Berkshire Hathaway, JP Morgan, Walmart and ExxonMobil.
In order to be listed on a stock exchange, a company must meet certain requirements. These vary from one exchange to the next, but typical requirements include an earnings test, and meeting certain thresholds for market capitalization, share price and number of shareholders.
Stock market performance
Two terms that are frequently used to discuss the stock market are “bull market” and “bear market.” In a bull market, stocks are rising, signalling investor optimism. A bull market occurs when a stock index, such as the S&P 500, the Nasdaq Composite, or the Dow Jones Industrial Average, rises 20% or more from a previous low over a period of two months or more. The S&P 500 has experienced 13 bull markets since the Great Depression in 1934. The most recent bull market, which ended this March, was also the longest at over 11 years.
In a bear market, stocks decline 20% or more from their previous highs over at least a two month period. However, there are many times when markets may drop but not quite enter bear market territory. If the market drops at least 10%, but less than 20%, it has entered a correction. The vast majority of corrections do not become bear markets - since 1974, there have been 24 corrections, of which only five became full-fledged bear markets.
Why do investors purchase stocks?
Investors favor stocks for a couple of reasons. Stocks are considered extremely liquid because they are relatively easy, fast and cheap to sell, making it easy to convert investments to cash if needed. Many investors also like that stocks provide passive income in the form of periodic dividend payments and price appreciation over time. Compared to bonds, historical stock market returns have been very attractive, averaging 9.2% over the past 140 years.
However, in the case of stocks, higher returns come with higher risks. Investing in individual stocks requires significant time and research to understand a company’s business model and growth potential. While you could pick a winning stock, you also run the risk of picking a loser that under-performs (or worse, goes bankrupt).
Although some of this risk can be mitigated by investing in exchange traded funds (ETFs), the stock market is inherently volatile. This trait has only been exacerbated by the COVID-19 pandemic. Volatility means that your investments can deliver outsized returns but also outsized losses. It’s also bad news for your portfolio over the medium- and long-term because it eats into your returns.
Farmland: an attractive alternative to stocks
For this reason, a diversified portfolio is essential for building lasting wealth. By allocating their investments to multiple asset classes, not just stocks, savvy long-term investors can reduce portfolio volatility and increase long-term returns. Fortunately for investors, there are some alternative investments that deliver comparable returns to stocks with significantly less risk, such as farmland.
One benefit of farmland investing is that its performance is uncorrelated with the performance of the stock market. This means that your farmland investments are protected from market corrections and economic downturns which destroy the value of the stock market. More than that, farmland is actually a good store of value during a recession. For example, from the beginning of 2007 to the end of 2009, the NCREIF Farmland Property Index was up nearly 30%.
Unlike the stock market, farmland investments are low-volatility. Farmland is significantly less volatile than both the stock market and traditional real estate, with volatility levels comparable to that of 10-year US Treasuries. Unlike bonds, however, farmland promises attractive annual returns in the form of both dividends and price appreciation. Between 1992 and 2018, farmland delivered total annual returns of ~10%. Farmland is supported by strong market fundamentals: at the end of the day, the global population continues to grow and people need to eat.
Disclaimer: FarmTogether is not a registered broker-dealer, investment adviser or investment manager. FarmTogether does not provide tax, legal or investment advice. This material has been prepared for informational and educational purposes only. You should consult your own tax, legal and investment advisors before engaging in any transaction.