Investing in the financial markets can be a complicated matter. At Cedarstone, one of the things we like to constantly drive back to is our understanding of the fundamentals including how securities work and what their relationships are to one another. With that in mind, here is a quick refresher on two of the most common investing vehicles: stocks and bonds.
The most important thing to remember about stocks is that they represent ownership. When you purchase a share of a company, you are purchasing a tiny slice of that company. In doing so, you participate in the financial successes and failures of the company. The risk of owning a specific stock has a lot to do with the risks present for its specific company. A share in an older, well-established company will be less risky than a share in a hot new startup which has a greater potential to fail. Of course, there are tradeoffs that come with taking on risk. The hot new startup knows that it’s a risky investment and consequently will offer higher return prospects to compensate for the greater risk. Owning stocks makes sense for individuals in the accumulation phase of investing who are looking to grow their assets over a longer time period.
The most important thing to remember about bonds is that they represent a loan. When you purchase a bond you are in effect lending money to a company, municipality or other organization. In return, that entity compensates you in the form of interest and then returns your money at the end of the bond agreement period (or term). Bonds are considered less risky because they are higher up in the capital structure. What this means is that when a company goes bankrupt, bonds take priority over stocks in terms of who gets paid back with whatever money remains in the company. Owning bonds makes sense for individuals in the preservations phase of investing who are looking to generate sufficient returns on their assets to fulfill a long-term goal but who can’t afford to lose a significant portion of those assets.
One of the reasons why investors are often encouraged to own both stocks and bonds in their portfolio is because two types of assets typically function differently in different environments. Stocks tend to do better when economies are thriving and companies are growing. Bonds tend to do better when economies are struggling and companies must pay more to borrow money. These contrary risk-return profiles have traditionally made stocks and bonds complimentary such that when stocks have struggled, bonds have done well and vice versa. This has historically been their relationship, however, there are times when their risk-return profiles can be more aligned and the diversification effect is less present.
If you’d like to learn more about how we invest, we invite you to explore our insights or give us a call.