Key Concepts and Summary
17.1 How Businesses Raise Financial Capital
Companies can raise early-stage financial capital in several ways: from their owners’ or managers’ personal savings or credit cards, and from private investors such as angel investors and venture capital firms.
A bond is a financial contract through which a borrower agrees to repay the amount that was borrowed. A bond specifies an amount that will be borrowed, the amounts that will be repaid over time based on the interest rate when the bond was issued, and the time period until repayment. Corporate bonds are issued by firms, municipal bonds are issued by cities, state bonds by U.S. states, and Treasury bonds by the federal government through the U.S. Department of the Treasury.
Stock represents ownership of a firm. The stock of a company is divided into shares. A firm receives financial capital when it sells stock to the public. A company’s first sale of stock to the public is called the initial public offering (IPO). However, a firm does not receive any funds when one shareholder sells stock in the firm to another investor. The rate of return on stock is received in two forms: dividends and capital gains.
A private company is usually owned by the people who run it on a day-to-day basis, although it can be run by hired managers. A private company owned and run by an individual is called a sole proprietorship, while a firm owned run by a group is called a partnership. When a firm decides to sell stock that can be bought and sold by financial investors, then the firm is owned by its shareholders—who, in turn, elect a board of directors to hire top day-to-day management—and is called a public company. Corporate governance is the name economists give to the institutions that are supposed to watch over top executives, although it does not always work.
17.2 How Households Supply Financial Capital
All investments can be categorized according to three key characteristics: average expected return, degree of risk, and liquidity. To get a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary, an institution that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit. Under the federal deposit insurance program, banks purchase insurance against the risk of a bank failure.
A typical bond promises the financial investor a series of payments over time, based on the interest rate at the time the bond is issued, and then repayment of what was borrowed. Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high-yield or junk bonds. The bond yield is the rate of return that a bond promises to pay at the time of purchase. Even when bonds make payments based on a fixed rate of interest, they are somewhat risky, because if interest rates rise for the economy as a whole, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss.
Changes in the price of a stock depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies. A manager of a mutual fund purchases an array of stocks and/or bonds. An investor in the mutual fund then receives a return depending on the overall performance of the investments made by the fund as a whole. A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund.
Housing and other tangible assets can also be regarded as forms of financial investment, which pay a rate of return in the form of capital gains. Housing can also offer a nonfinancial return—you can live in it.
17.3 How to Accumulate Personal Wealth
It is extremely difficult, even for financial professionals, to predict changes in future expectations and thus to choose the stocks whose price is going to rise in the future. Most Americans can accumulate considerable financial wealth if they follow two rules: complete significant additional education and training after graduating from high school, and start saving money early in life.