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Securities: Definition, Types and What They Mean for Investors

Securities are the tools of the trade in the investment world - and deserve closer consideration by investors.

Securities are the lifeblood of global financial markets - financial instruments designed specifically to give owners all kinds of options - buy, sell, hold, take cash dividends or give holders ownership rights and debt rights, as well.

What Is a Security?

The U.S. Securities and Exchange Act partially defines the term "security" the following way:

"The term 'security' means any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement."

Securities are traded on financial exchanges around the world, such as the New York Stock Exchange, the Nasdaq, the London Stock Exchange, or in the case of fixed-income investments, in the secondary markets. Mutual funds and exchange-traded funds hold securities in their portfolios, and are sold by investment firms, banks, and other financial institutions.

But any security must be vetted beforehand, prior to being issued to the public. For instance, a large company may want to go to the capital markets (the technical name for the stock and bond markets) to raise money for future endeavors, like research and development, more hiring, or for the construction of a new manufacturing plant, among other reasons.

That large company must hire an investment banking firm to examine the company's financial numbers against the amount of cash the company is looking to raise. Then, the investment banking firm goes back to the company and recommends the best uses of the securities market to raise that capital, usually through the issuance of stock or bonds on the trading markets, and offering those securities to the investing public.

History of Securities

Financial markets and securities have been around since the dawn of the civilized world. In ancient Greece and in the heyday of the Roman empire, money lenders swapped debts with one another on a daily basis, and soon began trading not only private debt, but government debt (i.e. bonds) as well.

In the 13th century, Italian merchants started trading the debt of other governments, too, acting as brokers between individual buyers and sellers in clinching deals, and getting a cut of the price in the deal. The first recognized stock exchange came in 1531, when Belgium financers open up a stock exchange in Antwerp, where debt and credit were traded among newly-minted brokers and lenders.

Back in those days, most security trades came in the form of promissory notes and government bonds. Stocks weren't traded at the time, but eventually started trading in ensuing decades as private business owners and investors woke up to the notion that pairing up financially would bring ample cash rewards.

What Are Different Types of Securities?

In the U.S., stock exchanges cropped up just as the new nation was getting on its feet, with the first exchange opening in Philadelphia in 1791, with another opening in New York the following year (the New York market was opened by brokers and lenders plying their trades under a tree located on Wall Street, in southern Manhattan.)

The same model still applies for securities 228 years later.

After all, having a financial instrument available to trade on an open, public trading exchange provides a healthy dose of stability to the investment world - and it builds some much-needed trust and credibility with investors.

While stocks and bonds (more on those securities below) are the most common form of publicly-traded securities, they're not the only ones. Investors can also buy and sell mutual funds, U.S. Treasury securities, derivatives, debentures, and warrants.

What all of the above securities have in common is the ability to have value and be traded openly between buyers and sellers. What they don't necessarily share is the same risk characteristics. Everyone's risk tolerance is different - what allows one investor to sleep better at night may keep another investor awake.

For example, stocks carry a greater potential for investment loss than bonds do, as stocks are more vulnerable to economic and market fluctuations.

Stocks also provide more profit potential than bonds, as stocks are considered by economists as highly useful for capital appreciation (i.e., earn higher investment returns). Bonds, on the other hand, are structured more conservatively, and are viewed as good instruments for capital preservation (i.e., it's more valuable to hang on to the money you've already earned.)

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Let's take a deeper look at stocks and bonds, the two most common forms of investment securities, along with a look at a third security traded on the markets - derivatives.

1. Stocks

Wall Street has no shortage of investment flavors when it comes to stocks.

Common stocks are securities (also called equities), sold to the public, that constitute ownership in a corporation. Stocks come in all sizes and flavors-investors can choose a large-cap company that's been around for a century or a micro-cap company that has just begun to take flight. Or, investors can select an international stock or sector-specific stock, to better add diversity to their investment portfolio.

Stocks are the most common form of investment securities for a good reason - they return the most money back to investors. Industry data shows that over a 50-year period between 1959 and 2008, stocks generate an average annual investment return of 9.18%.

Meanwhile, over the same time period, bonds returned 6.48%, on average.

As noted above, there are also different categories of stocks, any one of which could meet the needs of serious investors. For a shortlist, such stocks include blue-chip, growth, small-cap, cyclical, defensive, value, income, and speculative stocks, and socially responsible investments (SRI), among others.

2. Bonds

Otherwise known as debt securities and fixed-income investments, bonds are basically investments in public or private debt.

When investing in debt securities, the investor is essentially purchasing debt security, issued by a government or business, who then uses the money invested for their own, legal purposes (usually to fund projects and invest in the various operations a government or a business is involved in.)

In return, the bond investor received periodic security repayments, at a fixed rate, and over a specific period of time. A bond investor will receive the money he loaned to the bond issuer, plus interest until the bond meets its obligated maturity "due" date.

It's worth mentioning that banks can get in the debt security game by issuing certificates of deposit to customers, in return for a fixed rate of interest, but usually over a shorter period time compared to traditional bonds.

Bonds are deemed less risky than stocks, as governments and companies that issue bonds are more stable and secure than, say, a small company issuing its stock for the very first time. That doesn't mean bonds have no risk - they do. Companies may default, and there's always the risk that bond interest rate returns may not keep up with the rate of inflation.

3. Derivatives and Options

There is a third direct form of securities called derivatives, which are perhaps best personified by equity options contracts. They're less likely used by the general public, but derivatives are swapped all the time by investment firms, banks, and companies to make bets on the direction of various companies and industries.

For example, an equity options contract gives the contract buyer the right to buy or sell shares in a company, at a specific price and by a specific date down the road. The right, known on Wall Street as a "premium", is similar in make and model to an insurance premium, which pays out a return after a specific period of time.

Main Street investors would do well to steer clear of derivative-type securities. They're highly complex in nature, they represent an abundant risk of losing all of an investor's money, and aren't as tightly regulated as traditional stock and bond markets.

The Takeaway on Securities

It's ironic that most investors pour their hard-earned money into global securities markets and don't really comprehend the meaning of the term "securities."

That's a big reason why any investor should get up to speed on what securities are, how they work and the risks involved in steering money into a specific market category. In that regard, a little knowledge isn't enough - you'll need a lot of knowledge to go a long way.