Understanding the Mathematics of Personal Finance
SHORT SALES
So far, this chapter presumed that the way to make money is to “buy low, sell high.” This is true, but it isn’t the only way to make money. Buying a stock in the hope that its price will rise is called “going long.” Conversely, if you think a stock’s price will fall, you can “go short” or “sell short.” The way to do this is to arrange to borrow some stock that is selling at, say, $25 a share, and selling it. When the price falls to $20 a share you buy back the stock, return the shares and any costs for the loan, and keep the difference. If the stock price goes up instead of down, you’ll have to pay more than you received when you sold the stock, and you’ll lose money on the transaction.
Corporations may declare dividends. A dividend is a portion of the company’s profits that are returned to the shareholders, the amount being calculated on a per-share- owned basis. Examining the dividend policy and history of a company is useful, especially when looking at very nonvolatile companies, in trying to predict the value of the company’s stock. For example, if a stock is selling at $10 a share and the company has historically never missed a $0.10 per share quarterly dividend, then you could earn a 4% return on your money just for holding the stock for a year when the stock price doesn’t budge.
A stock represents a part of a company owned by the stock purchaser. A bond, on the other hand, is a loan. A corporate bond is an “IOU“ for money loaned to a corporation; a government bond is money loaned to the government. Various governmental bodies (federal, county, city) issue bonds. Because government bonds are considered to be very secure, they usually offer a lower interest rate than do corporate bonds.
The resale value of a bond depends on the interest rate the bond pays and the interest rates available elsewhere. If I have a bond that will repay $100 on its maturation date 1 year from today that is paying 5% annual interest, then I should be able to sell the bond today for the present value of the $100 repayment plus the present value of the year’s interest.
Calculating the present value of course requires the assumption of an available interest rate. If that rate is very low, then the value of my bond today goes up. Conversely, if the available interest rate is very high, then the present value of moneys due to me a year from today goes down, and my bond value goes down with it.
Just as you can invest in mutual funds for stocks, you can invest in bond funds.
