Investing for Young People Part 2: The Difference Between Stocks, Bonds and Mutual Funds

Stocks and bondsMagnifying glass

How to Pick your Stocks

Now that your child is proficiently handling their chequing account, making debits and deposits responsibly, and has assessed their risk tolerance, it is time to locate an investment vehicle that will see their savings dollars grow.
While an allowance and monetary birthday/holiday gifts might line the accounts, authoress Katherine R. Bateman, in her book The Young Investor, suggests that your child make a list of the things he or she is good at, or likes doing, and from that list derive ways in which they can earn money from those activities themselves. She states an example wherein one young person sold items from his lunchbox in elementary school, and later created his own lawn maintenance company by taking out a small loan with which to purchase a mower, trimmer and grass blower. When his client base grew he purchased better equipment and expanded his services.
Regardless of whether your child selects flyer delivery, babysitting, dog walking or snow shoveling, in generating their own funds he or she will be more involved and studious in the investment process. They will be, after all, putting their own hard earned dollars at risk. It is important that the difference between investments, and their potentials for loss and gain, are made well clear prior to their making any commitments.
Bateman reminds readers that by purchasing bonds one is in essence lending a company funds for which they are paid interest, while in purchasing shares one is actually purchasing a piece of the company pie. Should that company prosper, the pie piece becomes more valuable, or may even split to provide the shareholder with more shares; but should the company suffer, so too may the piece of pie reduce to mere crumbs.
While stock trading falls into a higher risk category for loss, it also offers the possibility for greater reward. However, if losing big is not something your child is ready to face, bonds are a somewhat safer place to start out. Bonds also require a more moderate learning curve, sparing the investor stock market lingo, penny stock scams, and market maker tricks.
Another somewhat happy medium for the young investor may be to purchase into mutual funds, which hold interest in a variety of shares in different companies. This way if one company represented in the funds fails, the other companies represented may hold up the fund’s value and thus less, if any, monies will actually be lost.
As a mutual fund is managed by one or several professionals, the investor is required to do less work than they would if trading stocks. The child may still select what type of mutual fund they are interested in: whether that be new or old business, real estate or technology focused, Canadian, U.S. or global funds, money market, specialized, fixed or dividend.
If investing for the long term the child may consider putting the larger part of their savings into an equity fund slated for growth over many years, while keeping a smaller portion of savings free for more volatile investments in stock. Keep in mind that mutual fund managers charge a fee for their services. Try to select a fund that shows promise but charges a reasonable commission rate (less than two per cent).

Stock Brokers, Stock Tables and Placing your Order

Bateman suggests that a child interested in purchasing stocks should first do some online research, or if someone in the family is already an investor they may lend their investment reports to the child for reading. While understanding every word in a quarterly report is not necessary, getting a general idea of how the company/investment is doing is. Bateman recommends the child Google one of their favourite company’s annual reports, take a look at growth over the last quarter or reported period, have a read-over the president’s message, and try to discern whether this company reflects growth or stagnation.
Children can also do quick searches of the more popular stock markets where the companies they are interested in purchasing shares in might trade, such as the New York Stock Exchange (NYSE), the NASDAQ or the Toronto Stock Exchange (TSE).
Sounds like a lot of discernment for someone in grade school – but starting out is just about getting the basics. Learning how to read stock tables and watching stock activity can become a fun bonding activity between both of you. Without risking too much, you can always enter into the stock market by purchasing from an account that allows a low limit buy-in.
Although there are many classes of stocks, let’s assume your first purchase will be in common stock (as oppose to preferred). You will basically have two options as to where you go to purchase these: a discount brokerage or a full service brokerage. While both should provide a platform containing data on the companies trading on the exchanges they represent, only the latter will be able to offer you guidance. This means helping you to select stock based on your tolerance of risk, experience and investment aims.
As a first-time stock purchaser guidance will more than likely be an asset. Your broker can aid you in placing your first order. You will still need to identify the following:

  • The name of the stock you want to purchase
  • The class of that stock (and whether they are common are preferred)
  • How many shares you want to purchase (or later on to sell)
  • Your established price

The best way to choose these wisely is to learn how to read a stock table. Bateman gives the following example for someone looking into purchasing shares in Disney. Disney trades on the NYSE. A quick Google search or a flip through the financial section of a major publication and you should be able to locate it. Disney could appear in a stock table as follows:
43⅞ 23⅜ Disney .21 0.5 85 360736 43 38 42¼ + 4⅖
The first number indicates the highest value the Disney share has sold for in the past 52 weeks (the 52-week high), while the second number the lowest (52-week low). If the high number has an upward facing arrow next to it that means that today was the highest value the stock has reached in the last 52-weeks. Concurrently, if the low number is attributed a downward facing arrow, today was the lowest value reached in a 52-week time span. In this representation the decimal, or cents, are displayed as a fraction. In numeric value this equates $43.88 and $23.38. Disney is, obviously, the name of the stock. Sometimes this might appear as an abbreviation, such as BarnNbl for Barnes & Noble.
The next number is the dividend that the stock holder might expect to receive per share. In this case the prediction is $0.21 per share. The following number indicates the percent yield. This number can be derived by taking the current value of the share and dividing it by the dividend (0.21). Eighty-five indicates the price to earnings ratio (P/E). In general, you want this number to be low as it indicates the difference between the price the share is selling at and the actual amount the company earned per share. In this example, Disney shares are selling for 85 times the actual amount of revenue they are bringing in.
The largest number on this line is the sales or volume made that day in 100s. This means that about 3.6-million Disney shares traded that day. This is an important number to look at. The next number is the highest price paid for a share that day, followed by the lowest amount paid for a share that day. And finally you have the last price paid for a share the previous day, followed by the change between the previous day’s closing price and the closing price for the day before that.
This example highlights a few red flags. Number one, the stock is currently being purchased at roughly its highest value in the past 52 weeks. You want to get a good price for your stock. Secondly, the stock is only offering a 21 cent per share yield per year, meaning that if you purchased 100 shares you would spend roughly $4,244.00 and earn about $21.00 annually (0.5% yield). Lastly, the stock is being sold fervently and way over-valued in relation to its actual earning power.
Knowing these numbers and how to read them will help you to make choices that make sense and could steer you away from stocks on the verge of a major correction. You may want to create a chart that lists these numbers for a stock over time (Example: at current, six months ago, one year ago, and five years go) to see how the stock has fared in the long term. In doing so, you are conducting your own stock analysis.
When placing a stock order you have the ability to place a market order, meaning you buy at the current market price; a stop order, which specifies to the broker at which price you are willing to buy or sell a stock (Ex. when stock ABC falls to $9 per share buy 1000; when stock XYZ falls to $7.50 sell); or a limited order, which allows your broker some flexibility to gain a better selling price or a lower purchase price. In addition you have the ability to set a time frame in which your broker can make the order: usually by the day’s close (a day order) or a good-till-cancelled (GTC) order, meaning the order will be open until it is fulfilled or until you opt to cancel it. Your stock broker will charge a commission for their services.
If you, however, choose to go the route of the discount brokerage, sites such as allow one to open account with a minimum $1,000 deposit, and make trades for $4.95 each. These sites do offer some live help, e-mail assistance and call back features should you require assistance.

Picking your Stocks

Amid economic difficulties people tend to spend less, but there are are always the old faithfuls that people can’t go without. When deciding what to invest in take a look around you and do some research. Are housing starts up? Are people purchasing cars? Which types of companies are closing their doors? Which are expanding or increasing their presence?
Stocks in utility companies tend to be popular portfolio residents, in addition to consumer staples or popular consumer goods. This can mean comfort food like frozen fries to a specific brand of toothpaste that has taken off, or a cell phone that everyone is upgrading to.
Remember that diversification is usually the key. If your child is keen on investing solely in stocks, consider dividing savings into three pools for three different stock investment options. If stocks still seem too complex stay tuned for the Investing for Young People Part 3: reading mutual fund reports and defining the different types of mutual funds.

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