money banking and finacial marketsExplain why being a residual claimant makes stock ownership risky
In relation to stocks, in general, stocks, residual equity claims, are only traded on the stock market, therefore their residual characteristics do not come into play and therefore do not materially add to a stock's other risk factors. Only when a business is closing its doors, for one reason or another, and settling its debts does the residual characteristic of equity investments become an active risk factor. It is then, when a business is closing, that the total liabilities must be met before residual equity claims are met: (total assets - total liabilities) - residual claims.
The problem with residual claimant is that they are the very last to gain any profit from any stocks. This means that the payback or any profit that the claimant will see from these will be so much less than the profit that others will make in the pipe line. As a residual claimant you are last in the line and your profits will be so much less than everybody else.
The simple reason why residual claimants are risky is because you only have claim to the "left overs." As you know all people are greedy for money and as much as they can get. For this reason, if a company goes under, then you will probably not get anything, if you are last in line. Hence, the risk is built into owning the company.
If you mean in comparison to bond ownership, it is more risky, because as a residual claimant, your claim is based on total assets after total liabilities are subtracted. The more liabilities a firm takes on, the less return you get. This is not so with a bond, which guarantees a fixed rate of return.
The residual claimant can be seen as the last person in line for his/her share in a given amount of money. There are all these other people ahead of you in line and they have to be paid off. You only get paid if there's something left over. So you risk not getting anything at all.
Basically, you don't want residual anything. Residual means left over. Think of it this way. You go to a party and you're the last one there. You get the residual chips and soda, meaning the worst soda and the crumbs on the bottom of the bowl.