What ARE Stocks & Bonds?!

In this solo episode, Nikita covers the basics of stocks & bonds; how they are traded & the relative risks associated with investing in them. 

If you already understand the basics of investing, consider sharing this podcast with a friend or family member who could use a little primer.

Transcript

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Hi 3rd Decade Community, I’m your host Nikita Wolff & today we’re going to do a deeper dive on stocks and bonds, and how both of them can serve our retirement portfolios at different stages.  

Here at 3rd Decade, we teach that successful investing is as easy as determining the correct allocation of stocks and bonds based on the time horizon of the goal, consistently buying those assets, and holding onto them in the long term. We often refer to using low cost index funds that mirror an index like the S&P 500. But what is the S&P 500? For that matter, what is a stock or a bond anyway? In this episode we will provide a basic overview of these types of securities, how they are traded and the relative risks associated with investing in them. If you already understand the basics of investing, consider sharing this podcast with a friend or family member who could use a little primer. Alright, let’s dive in.

A stock is a piece or share of ownership in a company. Companies sell shares of ownership, also called equity, in their firms, to raise capital, typically to fund new projects and to be able to grow without having to take out loans. If the company becomes more valuable, those little pieces of equity also become more valuable. Some companies pay dividends to shareholders out of their profits which can be reinvested in the company by buying more shares, effectively compounding the investment.

In contrast to shares of ownership, bonds are a type of debt instrument. You may be familiar with government bonds like Series I or EE Savings bonds. Generally speaking, the word “bonds” refers to all government securities including bills and notes. Corporations can also issue bonds as a way to raise capital. Bonds have a stated interest rate that’s based on the federal funds rate at the time of issuance. Think of a bond like a promissory note. If you lend me money, I sign a promissory note which states the terms of the loan. Maybe you lend me $10,000 and I promise to repay the $10,000 with interest. You give me $10,000 up front, I pay you interest, typically on a monthly basis, until the note becomes due at which point I have to pay you back your $10,000. 

A bond acts the same way. Government entities, including the US government, and local municipalities issue bonds to raise working capital and pay bondholders interest out of the taxes they collect. Corporations also issue bonds and pay the interest out of their earnings. Because bonds pay a pre-stated rate of interest, these types of investments are also referred to as fixed income instruments. Unlike stocks, the rate of return is fixed and knowable ahead of time. An important factor to consider when purchasing bonds from an entity is their creditworthiness. “Junk bonds” or high-yield bonds are extremely risky because of the low credit rating of the underlying companies. An entity's credit rating indicates their capacity to repay the loan.

Most of us will invest in stocks and bonds through the use of mutual funds where an investment company pools money from multiple investors and buys stocks and bonds en masse according to the fund’s stated objectives. When you buy stocks through a mutual fund, you will own little pieces of a bunch of different stocks. You may not even own a whole share of an individual stock, but your little piece is still owned by you and allows you to participate in the potential growth of the companies in which you are invested. By the same token, if you own shares of a bond mutual fund, the fund will get paid interest by the bond issuers and you will get your portion of those interest payments in ratio to how much of those bonds you hold in your shares of that fund. Confused? Stay with me.

Say I want to participate in the potential growth of all publicly traded companies in the US, but I only have $1000 to invest. If I were to try to buy individual shares of all those companies, I’d be out of luck since many shares cost more than the whole $1000 I have available. But I could buy $1000 worth of a Total US Equity mutual fund. Same thing with bonds. Bonds are sold at face value and typically range from $25 to $1000. There’s no way I could buy all available types of bonds with my thousand dollars. I could, however, buy shares of a Total Bond fund and own little pieces of many bonds that way.

The stocks and bonds found in your mutual fund are typically not purchased directly from the issuing entity. They are usually bought and sold second hand through an exchange or, in the case of bonds, over-the-counter. Exchanges, like the New York Stock Exchange, exist to facilitate the buying and selling of securities in the open market. When you buy stocks and bonds through a fund, your price will be based on what the underlying securities are going for on the exchange. Security prices reflect investor sentiment and expectations for the future. This is why stock prices fluctuate so wildly on a day to day basis. Market participants are all betting on whether companies will be successful in the future. Bonds also fluctuate, but to a lesser degree, in large part because their value is more easily defined since they pay a fixed interest rate.

When you buy shares of a mutual fund today, you are buying small pieces of all of the underlying securities in that fund. You are paying the price market participants have determined those securities are worth today. The hope is that when you go to sell your shares of that fund, the price will have increased because the value of the underlying securities will have increased. 

At this point, you should be asking yourself, “How do I know if the stocks I buy today in these funds will be worth more when I sell them?” Good question. Historical data shows a very reliable pattern. When looking at the market as a whole, meaning all companies available to trade on the open market, if you take any 20 year period and pretty much any 10 year period, the whole market returned more than 9%, around 4-6% over inflation. Around here we like Warren Buffet’s quote, “If you aren’t willing to hold a stock for 10 years, you shouldn’t even think about owning it for 10 minutes.” Now, that doesn't mean every stock or bond will go up by that amount, or that there won't be periods of time where the market has a negative return. But over the long term, the historical trend has been for the market as a whole to increase in value. This is why we stress the importance of holding onto your investments and not reacting to short-term market movements or headlines.

Most of us are going to mainly use investments to prepare for retirement which means we have a long term time horizon. Think the phrase, “decades equals stocks.” A diversified portfolio remains a very historically justifiable way to expect to beat inflation and grow your money steadily and reliably over your working life. Anything other than investing per the time horizon of the goal is just gambling. In saving for retirement, the stock market should be thought of as a long term investment tool. Buying positions in a globally diversified stock portfolio consistently and holding onto them for a decade or more is a very historically reliable way to grow your money at a faster rate than the increasing cost of goods and services.

Earlier, we referred to index funds and the S&P 500. An index fund is just a type of mutual fund where the securities that are held in the fund are based on the parameters of a specific predefined list. The list might be all companies of a certain size or within a certain geographical area. The list might only include companies that sell a certain type of product or group of products. The list could have multiple parameters like only small companies in certain countries and in specific sectors. The S&P 500 is Standard and Poore’s list of the largest 500 companies in the United States. With index funds, the fund’s objectives are to always hold the securities that are defined by that list. This means that there’s not a whole lot of trading going on. Index funds don’t cost much to run since no one has to pay expensive fund managers to pick and choose which securities to hold within the fund. And since the data strongly shows that fund managers aren’t successful at beating the market as a whole, that leaves more of the investor’s money in the broad market, decreasing the likelihood of missing out on potential growth.

Now let’s talk about why stock prices fluctuate so dramatically. Remember, all the stocks and bonds held inside of a mutual fund are bought and sold on the open market. This means that prices are reflective of current market participant sentiment. Some people who are buying and selling securities are trying to make money in the short term. Of course, this is purely speculative since no one knows what will happen with a specific stock or sector in the future. If I have stock in a company and I think the value of my positions will go down, I might try to sell. If I think a company will be worth more in the future, I would probably want to buy stock in that company today. When a lot of market participants have the same expectations, prices will move accordingly. 

Let’s look at an example. When Russia inv   e economy, so I’ll sell all my stocks now before things really go downhill.” But when prices get low enough, at some point everyone’s thinking, “Surely these stocks are worth more than this” and they start buying again. Market prices might increase rapidly as people try to buy stocks while costs are still relatively low, creating demand which drives prices upward. This is a simplistic explanation. Of course there are other forces moving market prices as well, but these basic concepts still apply. Remember, whenever a stock is sold that means that someone else thinks the stock is worth at least that much or they wouldn’t buy it. Again, it’s all speculation if you’re looking at short term market movement.

If stock prices move up and down wildly and without warning, why would anyone want to invest their retirement funds in stocks? Again think, “decades equals stocks.” Think about how much money you would need to sustain your lifestyle if you weren’t working anymore. Where would that money come from? You would need to have some type of investment that paid you monthly or annually enough money to live on. Stocks and bonds pay investors dividends and interest. Some people run rentals. You could sell a business or invention on an installment loan. Some people will get a pension payment from their employer. A pension fund is like a big mutual fund where pension managers decide how to invest the funds in a way that will pay pensioners now and later. Most of us will not inherit enough money to live off of in retirement and will need to buy investments through our working life to build our nest egg. 

The reason we, at 3rd Decade, focus on a diversified stock portfolio is because that strategy typically works for anyone with the discipline to save and the patience to let it grow. Not all of us are cut out to be landlords, run businesses, or create inventions. But, if you have some source of income and can regularly save a portion of it in tax advantaged retirement accounts, there is a great likelihood that you’ll have something to live on in your later years. That’s because while the stock market fluctuates wildly in the short term, give it a decade or more and it will very likely average a return that soundly beats inflation, doubling your investment every decade or so. Those who have a long time until they retire will be able to invest more of their portfolio in stocks than someone who is retiring soon and those in retirement will need to invest a larger portion of their portfolio in fixed income instruments paying interest. But until very late in life, you will probably want at least a portion of your investments in stocks.

Now, a word about “risk.” Most people use the word risk to describe the likelihood of your invested balance decreasing. It’s true that if you have a mutual fund portfolio of stocks and bonds, you will experience loss at times. But the real risk is that your money doesn’t grow fast enough to outpace the increasing costs of goods and services. If you save your money in a bank account, you eliminate the risk of loss of principal but the value of your money will actually decrease over time as the purchasing power of those dollars diminishes.

We prefer the term “volatility” because risk sounds like something that should be avoided whereas volatility describes a natural characteristic of all investing. Stock prices are more volatile than bond prices. But the relationship between risk and reward is immutable. Higher risk or volatility also means higher long term growth. Low risk or volatility will come with lower returns. In fact, the reason that stocks are able to beat inflation by such a large margin is because of their short term volatility. Speculators are driving those returns. If stock prices were stable, people wouldn’t have to guess as to their future value. This “betting” process is actually what sustains the healthy long term returns of stocks.

We hope now that you better understand the basics of investing that you will feel more confident about regularly and systematically buying a globally diversified stock portfolio and holding your positions until your personal financial plan necessitates a change. Remember to tune out the noise and focus on what you can control to reach your goals and live your best life!

Thanks for listening!