Common Cents

Cut through the jargon: Stocks & Bonds

A 2018 BBC article noted that “there are an estimated 171,146 words currently in use in the English language.” We have a lot of words and the financial services industry is not shy about complicating straightforward concepts by creating, recreating, and confounding us with an endless alphabet soup of words and acronyms.

We discussed setting up your accounts in a way that covers the short term, the long term, and general investing. The next step is to invest that cash in assets that should increase in value over time. Let’s consider the most common categories of investment assets and try to pave a simple road through Wall Street’s jungle of jargon.

“Everything should be made as simple as possible, but no simpler.” – Albert Einstein

A traditional investment account will include stocks, bonds, and cash. Other asset types are typically referred to as “alternative assets”.  We are going to focus on stocks and bonds.

Stock:

  1. What is it? Stock represents a share of ownership in a company. Fundamentally, a single share of stock in a company starts with a value equal to the difference between all of the company’s assets minus its liabilities and then divided by the total number of shares issued (“book value”). Since stocks entitle the holder to a share of the company’s current and future profits the actual price that stocks trade at will typically be much higher due to expectations of future earnings and net asset value.
  2. Why buy it? Stock entitles you to a share of the company’s profits and allows you to participate in the potential increase in value of the company which will increase the price of the stock. The more attractive a business appears, the higher its stock price can rise.
  3. How much can I make? There is no limit to how much you can make. Historically, the US stock market has returned ~10% annually, but what this really means is that some years you will make much more than 10% and other years will be much lower.
  4. How much can I lose? As much as you put in (i.e. if the price of the stock goes to $0). There are ways to lose even more, such as through margin trading – stay away from such strategies.
  5. Common jargon? Stock(s), Equity/Equities, Securities

Bond:

  1. What is it? A bond is a loan. The borrower (issuer) is typically a large corporation or a government and the lender is the investor that purchased the bond. The borrower agrees to repay the loan over time with interest. The interest paid is income to the lender. Since the bond itself is an asset, most can be traded in the bond market similar to a stock. Interest rates play a major role in the pricing of a bond. When interest rates rise compared to the rate on an issued bond, the price of the bond will fall and when interest rates drop in the market, the price of the bond will rise. This makes sense since a higher interest rate in the market makes a previously issued bond at a lower interest rate less attractive.
  2. Why buy it? Investors seeking a reliable and predictable stream of income would prefer bonds. Bonds, especially those issued by developed countries or well established corporations are expected to make all of their interest payments on time while repaying their principal in full. Bonds issued by less creditworthy borrowers (“Junk Bonds” or “High Yield Debt”) will have a higher risk that the investor might not receive all of their interest and principal payments.
  3. How much can I make? You will receive as many of the interest payments as you are entitled to while you hold the bond. Additionally, since the trading price of a bond will change as market interest rates change, you might be able to sell a bond for more than you paid for it similar to selling stock.
  4. How much can I lose? As much as you put in – if the borrower defaults there is typically an ordering for creditors to recover their money, but oftentimes nothing or close to nothing is recovered. Losses can also occur for the investor who purchased bonds before a spike in market interest rates.
  5. Common Jargon? Bond, Fixed Income, Debt Securities 

In the longer-term stocks tend to outperform bonds, but in the shorter term they will swing in price much more dramatically. Bonds provide both a more predictable income stream as well as a relatively lower degree of price volatility.

Asset Allocation:

An investor with a longer time horizon and/or risk tolerance would want more stocks compared to bonds. Over time the balance from stocks to bonds should shift in order to preserve wealth previously built and reduce the risk of losing it in the next market downturn when an investor might have a shorter time horizon.

If you can’t beat them, join them:

Trying to time the market is hard, and even the most seasoned professionals don’t get it right. Warren Buffet once said “The only value of stock forecasters is to make fortune tellers look good.” Having an amount that you continuously invest is a smart way to get into the market, worry less about timing the market and worry more about being in the market!

How to actually sell high and buy low:

An investor should be mindful to rebalance their portfolio (although don’t over rebalance, the taxes could be a killer!). This means check the drift in your allocation between stocks and bonds and sell the asset that has appreciated to buy more of the asset that has depreciated. This forces investors to “sell high and buy low” something that is much easier said than done.

Our next article will go further down the investing rabbit hole as we explore individual stock and bond investing vs. fund based stock and bond investing. Stay tuned…it’s bound to get controversial!

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Elliot Pepper, CPA, CFP®, MST is Co-Founder of Northbrook Financial, a Financial Planning, Tax, and Investment Management Firm. He has developed and continues to teach a popular Financial Literacy course for high school students.