Although the time to purchase stocks and bonds is dependent upon interest rates, the methodology for making your selection is quite different. I often tell students that if investments were like high schools students, I’d like my bonds to be B/C students and my stocks to be straight A students. So what does that mean?
Straight A’s – Buying Stocks
When we look at the risk of owning stocks, we must always remember that common shareholders are the last priority to receive payment for failed securities. If you own stock in a company and comes across hard time and eventually becomes bankrupt, most likely you’ll lose every dime you invest. You see, when a company goes through the liquidation process, the equity that remains in the business is distributed in a certain order. This order is:
3. Preferred Stock
4. Common Stock.
By owning a company that’s highly leveraged, the chances of the business experiencing bankruptcy greatly increase. If such an event occurs, most of the remaining equity will be used to return investments to bank loans and bond holders. In most cases, these holders still lose money. As you can see, ownership of a common share requires an enormous amount of trust and confidence in the businesses ability to sustain operations during rocky times. Think of it from this perspective. Is it easier for an individual person to grow their wealth and avoid sluggish financial growth by avoiding debt? The answer to that question is obvious – yes. Well, owning stock in a company is no different. Avoiding businesses that carry a lot of debt often lead to profitable returns.
B/C Students – Buying Bonds
When a person goes to the bank to buy a home, they often get different interest rates than other customers. The reason is directly related to the risk of the borrower. When companies issue bonds, they experience the same thing from investors. If the business is not a stable and may experience difficult times in the years to come, investors will demand a higher return for their money. So how much of a return is a good return while still accounting for risk? Well this is a very important question to answer.
When we were dealing with stocks, the future returns of the business where directly related to the company’s ability to growth their profits and increase market share. With bonds, all we care about is the company’s ability to repay their debts. In the end, I could care less if the company’s product is successful in the long run. I just want to know if the product is successful enough for the business to continue operations. Like a student, I only care if they make a passing grade. If they do, they stay in school to fight for another day.
You see, stock investors are rewarded for exception performance. Bond investors are rewarded for owning the security that’s just good enough to continue operations. Although this mindset might seem brash, it’s the only way you’ll be able to align your assessment of risk versus reward for two very different types of securities.