A security is a fungible, negotiable financial instrument that has a monetary value. There are three primary types of securities, equity, debt and hybrids – which are a mix of debt and equity. Publicly traded securities are listed on stock exchanges, this helps them attract investors by providing a liquid and regulated market for them to trade.
An equity security can be in the form of an initial public offering (IPO) or they can be offered privately to a restricted and qualified group in what is known as a private placement. Companies may choose to sell stock either privately or publicly or as a mix of both.
How a security works
An entity such as a company creates securities for sale and is then known as the issuer, those who then buy the securities are known as the investors. Typically, securities represent an investment in which the issuer can use to raise new capital. For example, companies that go public with an IPO usually do so to raise capital for further businesses development.
Municipalities such as city, state or county governments may raise funds for projects by floating a municipal bond issue. Raising capital through the sale of securities is often deemed a preferred alternative to traditional financing such as bank loans.
In the US, the public offer and sale of securities are regulated by the U.S. Securities and Exchange Commission (SEC). Public offerings, sales and trades of securities must be filed and registered with the SEC’s state securities department.
The definition of a security was determined by the Supreme Court in 1946 when it stated that a security must meet four criteria:
The existence of an investment contract
The formation of a common enterprise
A promise of profits by the issue
Use of a third party to promote the offering
Types of security
The three types or categories of security include:
These types of securities are ownership interests held by shareholders in an entity, which can be a company, a partnership or a trust. An equity security is realized in the form of shares of capital stock and can include both common and preferred stock. Some but not all equity securities pay dividends and all provide the opportunity to profit from capital gains and give the shareholder voting rights.
A debt security is money that has been borrowed and has to be repaid. It will include terms that stipulate the size of the loan, interest rate and maturity or renewal date. Debt securities may include government and corporate bonds, certificates of deposit and collateralized securities.
Typically the holder will make regular payments that are made up of interest and principal payments. They can be secured or unsecured and are usually for a fixed term, i.e. 5 years.
These types of securities are a combination of equity and debt securities and can include equity warrants which are issued by a company and gives shareholders the right to buy stock within a specified timeframe and for a set price. Other examples of hybrid securities include convertible shares and preference shares.
Advantages of a security
The advantages of investing in a security include:
Easy to buy and sell
Available on the stock market either through a broker, a financial planner or online makes buying and selling securities easy. Equity stocks are generally considered to be liquid, meaning they can be quickly sold for cash if an investor needs to release their investment.
Can offer two ways to make money
Some securities pay dividends which can provide a regular stream of income as well as the opportunity to realize capital gains if an investor sells their securities for more than they bought them for.
Disadvantages of a security
The disadvantages of investing in a security include:
Can be high risk
As with any investment, there is always an element of risk. Should an investor make poor investment decisions or if the market becomes volatile they could stand to lose part or all of their investment. For this reason, it is important to do your research and seek advice before investing.
Time-consuming to manage
Individual investors who are buying on their own may find investing in securities time-consuming. From researching good investment opportunities to monitoring the markets and reviewing and analyzing companies financial statements.