Question

1. Why do people invest in stocks? Is stock a riskier investment than bonds? Why or why not? How is preferred stock similar to bonds? To common stock?

2. Why would economic growth affect the value of a stock?

3. What are the limitations of the generalized dividend model?

4.What are the risks faced by investors investing in stocks in emerging markets?

5.What is the motivation for buying foreign stocks?

Answer 1

(1): People invest in stocks for the simplest reason that stock, as an asset class, provides highest potential returns. Investors earn in the form of dividends that the stock pays and also in the form of appreciation in the prices of stocks leading to capital gains.

Yes, stocks are riskier investments that bonds because stock prices are subjected to market risks and hence can be very volatile. In fact a stock can potentially lose its entire value overnight. Thus stocks are riskier than bonds due to the high volatility associated with stocks. Bonds have a guaranteed return but stocks do not have a guaranteed return.

Preferred stocks are similar to bonds in the sense that both preferred stocks and bonds earn fixed earnings. While preferred stocks get fixed dividends bonds get fixed coupon payments. Secondly both preferred stocks and bonds may be convertible to equity and both may have a call provision.

Preferred stock is similar to common stock in the sense that both entail the stockholder to get a partial ownership in the company. Secondly both earn dividends and both can be traded in the secondary market.

(2): Economic growth affects the value of a stock due to the presence of systematic risk. Systematic risk is that risk that affects the entire market. Also stock prices are nothing but present discounted value of future earnings (DCF or discounted cash flow model). During times of economic growth the earnings if a company will rise and this will increase the present discounted value of its future earnings thus giving a stimulus to the stock price.

(3): The first limitation is that the generalized dividend model does not account for non-dividend factors like retention of the customers etc. There are certain non-dividend factors that significantly affect the value of a firm. Secondly the model assumes that growth rate cannot exceed the cost of equity and this assumption may not always be true.

(4): There are several issues and risks while investing in stocks in emerging markets. First of all there will be high volatility in the prices of these stocks, especially the mid cap and the small cap stocks. Secondly the level of transparency will be lower than in case of developed economies and this poses a risk in the long term. Thirdly there are liquidity concerns as liquidity in emerging markets is not as high as that in developed markets. Lastly investments in emerging markets have high exposure to political and geo-political risks.

(5): The primary motivation of buying foreign stocks is diversification of portfolio. Investors invest in foreign stocks to be able to participate in growth of other economies and to gain from it. Thus by investing in foreign socks investors will be able to get an additional layer of diversification and this will reduce their overall level of risk exposure. Investors will also gain from different cycles of boom which impacts different economies at different times.