Sid Roy
In our everyday conversations about money, we often assume that most people know what stocks and bonds are. At times it becomes apparent that some people don’t. A recent example is a casual chat with a friend of mine who wished she had a pension just like her dad. She did not understand why the stock market returns were so unpredictable and why could she not get a decent interest on her money without the uncertainty.
This conversation certainly made me pause and realize something. There are possibly more people like her who do not feel grounded in the basic vehicles of investment that we discuss here. And without understanding, there can never be sound investment management. So, let’s look at each of these in turn, the rewards and the risk associated with each.
First, let us talk about stocks or shares. The term “share” means a share of ownership. Long before the era of public companies, enterprises have been formed based on agreed upon shares between involved parties. The spoils of any such private enterprise would be divided among the parties. The first company to offer “shares” to the general public is apparently the Dutch East India company back in the 1600s. This, then, is the beginning of the formation of publicly owned companies where you could buy a small portion of the company (“share”) for a sum of money and get a share of its profits. The Dutch East India company made its money from spice and slave trade on ships that plied the oceans. When you picture such a company, it is easy to see that its fortunes are likely to ebb and flow over time. And therefore, the same is true about the returns for its shareholders.
A lot has changed since then. However, the meaning of owning a share or a stock in a company has remained the same. Your risks and rewards are directly tied to how well the company does over time as you are a fractional owner too. The Dutch East India company has long vanished. Just like it, many others have been formed, thrived, and finally faded away to newer ones. What this tells you is that the risk and return are fundamental to any enterprise that is trying to make money and cannot be wished away. Return on an investment is due to the new value an enterprise creates in the society, as measured by what its customers are willing to pay for its products or services. So, my friend would be well advised to accept that for all the shareholders – the passive and limited-liability owners of the company – there is no escaping the uncertainty.
Second, let us talk about bonds. While it might seem foreign, bonds have been around for millennia. People have been lending money to other people and getting an additional amount as return. The more reliable the person, the less risky was it for someone to lend that money and get their money back sometime in the future, while earning some interest as a compensation. If I had a stellar reputation for making good on my promises, I would also attract more people willing to lend me. And this might help me negotiate a smaller interest payment on the borrowed money. This in a nutshell is still what happens when an organization issues a bond today in exchange of money. It promises the holder of the bond a fixed return on the loan.
How are they different from stocks? First, the organization has a legal obligation to make its interest payments and pay-off the principal when bonds mature. If not, the creditors can come after the company’s assets and force it to liquidate. Second, the organization issuing the bond has found a way to earn more by investing your money in its business even when it promises to give you only a fixed amount in interest. And typically, it makes much more by investing in gainful enterprises. Any excess profit is shared with the shareholders, directly or indirectly, but not with the creditors. Stated differently, bondholders are promised a predictable investment return whereas stockholders do not get the luxury of certainty. Therefore, the returns from bonds are historically lower than stocks which are tied directly to creating new value.
What about risks? Bonds also carry risk. The principal returned at maturity may lose its purchasing power due to unexpected inflation. A company might go out of business after issuing bonds. But then, you can look at an organization’s history and see how reliably it has met its promises despite the uncertainty of the enterprises it is engaged in. So, you can sit back and just count your returns instead of worrying about every business venture it is engaged in. Of course, that also means that your returns are necessarily lower.
I shared this with my friend to help her overcome her hesitation in investments. She found it to be valuable to really “get it” finally. I hope if you are in the same situation, you might get something out of this article too.
Happy investing!