Stocks and Bonds

The balance sheet helps us understand the overall financial health of a company.

A major factor in determining financial health is the company's underlying capital structure.

What is the best way to capitalize a company?  Is it equity or debt?  The answer is that it depends, as both debt and equity have their advantages.


Debt

Debt offers the following advantages.

1.   Lenders have no direct claim on future earnings.  Debt can be issued without worries about a claim on earnings.  As long as the interest is paid, the company is fine.

2.  Interest paid on debt can be deducted for tax purposes.

3.  Most payments, whether they are interest or principal payments, are usually predictable, and so a company can plan ahead and budget for them.

4.  Debt does not dilute the owner's interest, and so an owner can issue debt and not worry about a reduced equity stake.

5.  Interest rates are usually lower than the expected return.  If they are not, a change in management can be expected soon.



Debt securities can take a number of different forms, the most common being bonds.

Bonds are obligations secured by a mortgage on company property

Bonds tend to be safer from the investors' standpoint and therefore pay lower interest.

Debentures, in contrast, are unsecured and are issued on the strength of the company's reputation, projected earnings, or growth potential.

Debentures, being far riskier, tend to pay more interest than do their more secure counterparts.




Equity

Equity has the following advantages:

1.  Equity does not raise a company's break-even point.  A company can issue equity and not have to worry about achieving performance benchmarks to fund the equity.

2.  Equity does not increase the risk of insolvency, and so a company can issue equity and not have to worry about any subsequent payments to service that equity.  Equity is essentially capital with unlimited life and so a company can issue equity and not have to worry about when it comes due.

3.  There is no need to pledge assets or offer by personal guarantees when equity is issued.



Equity can take a number of different forms.

A simple form of equity is common stock.

This type of stock offers no limits on the rate of return and can continue to rise in price indefinitely.

There are no fixed terms; the stock is issued and the holder bears the stock.

Preferred stock entitles the holders to receive dividends at a fixed or adjustable rate of return and ranks higher than common stock in a liquidation.

Preferred stock may have anti-dilution rights so that in a subsequent stock offering, preferred stockholders may maintain the same equity stake.

Convertible securities are highly structured in nature and are based on certain parameters.  As the word convertible indicates, they may convert into other securities.

Among the most common are warrants and options.

Warrants and options stand for the right to buy a stated number of shares of common or preferred stock at a specified time for a specified price.

There are also convertible notes and preferred stock, which refer to the right to convert these notes to some common stock when the conversion price is more favourable than the current rate of return.

"Gentlemen who prefer bonds don't know what they've missing."

Theoretically, it makes no sense to put any money into bonds, even if you do need income.

Take the case of a asset allocation of 50 percent of the money invested in stocks that grow at 8% and 50 percent in bonds that don't appreciate at all, the combined portfolio had a growth rate of 4 percent - barely enough to keep up with inflation.

What would happen if we adjusted the mix?

By owning more stocks and fewer bonds, you would sacrifice some current income in the first few years.  But this short-term sacrifice would be more than made up for by the long-term increase in the value of the stocks, as well as by the increases in dividends from those stocks.  

Since dividends continue to grow, eventually a portfolio of stocks will produce more income than a fixed yield from a portfolio of bonds. 


Peter Lynch



Additional notes:

1.  Once and for all, we have put to rest the last remaining justification for preferring bonds to stocks - that you can't afford the loss in income.
2.  But here again, the fear factor comes into play.
3.  Stock prices do not go up in orderly fashion, 8 percent a year.  Many years, they even go down.
4.  The person who uses stocks as substitute for bonds not only must ride out the periodic corrections, but also must be prepared to sell shares, sometimes at depressed prices, when he or she dips into capital to supplement the dividend.
5.  This is especially difficult in the early stages, when a setback for stocks could cause the value of the portfolio to drop below the price you paid for it.
6.  People continue to worry that the minute they commit to stocks, another BIG ONE will wipe out their capital, which they can't afford to lose.
7.  This is the worry that will keep you in bonds, even after you've studied and are convinced of the long-range wisdom of committing 100% of your money to stocks.


Let's assume, that the day after you've bought all your stocks, the market has a major correction and your portfolio loses 25% of its value overnight.
1.  You berate yourself for gambling away the family nest egg, but as long as you don't sell, you're still better off than if you had bought a bond.
2.  Computer run simulation shows that 20 years later, your portfolio will be worth $185,350 or nearly double the value of your erstwhile $100,000 bond.

Or, let's imagine an even worse case:  a severe recession that lasts 20 years, when instead of dividends and stock prices increasing at the normal 8 percent rate, they do only half that well.
1.  This would be the most prolonged disaster in modern finance.
2.  But, if you stuck with the all-stock portfolio, taking out your $7,000 a year, in the end you'd have $100,000.  This still equals owning a $100,000 bond.

Ref:  Pg 55 Beating the Street, by Peter Lynch.


FOR YOUR IMMEDIATE ACTION!!!

1.  TALK YOURSELF OUT OF OWNING ANY BONDS.
2.  AT LEAST, YOU SHOULD DECIDE TO INCREASE THE PERCENTAGE OF ASSETS INVESTED IN STOCKS, WHICH IS A STEP IN THE RIGHT DIRECTION.

Why Stocks?

Past performance is no guarantee for future performance.  There are no guarantees that any asset will thrive in the future because it has in the past.

This leaves two choices:

1.  Keep hard cash and save enough during your working years to last your retirement years; or
2.  Take some risks and invest the money in assets that have a reasonable chance of increasing in value over time.

Keeping cash:  Most people cannot save enough to support them in retirement especially when inflation continuously erodes the purchasing power of money.  Therefore, most would not choose this option.

Investing the money in different asset classes:  Here is where the problem of choosing investment options comes in.  It is definitely wise to spread your wealth across various asset classes like stocks, bonds, real estate, art or gold.

Why Stocks
Stocks increase in value faster than inflation decreases the buying power of money.  The best way to have money in the future is to make money in the future.  So, forget about which asset class will appreciate in the future but rather focus on owning a business that profitably sells products or services.  Of course, most do not have the inclination, the money or the skills to start their own business, so the next best way to share in the profits is through the stock markets.

Stocks represent ownership interest in businesses.  When you invest in stocks, you become a partial owner of the concern that will hopefully make money in the future.  Stock ownership will reward the owners either because the stock prices go up or because the firm/s profits will be distributed as dividends.  In the short period stocks may rise for reasons having nothing to do with profitability or dividends.  But over the long periods of time it has been proved that stock prices rise in relation to a company's earnings and distribution of profits to shareholders in the form of dividends, bonus share and rights.  Learn and acquire the knowledge to consistently identify specific companies that will thrive.  In the absence of this ability, employ the services of a professional.

If you don't plan to tap into your long-term savings for a period of at least five years, stocks should probably constitute the bulk of your portfolio depending upon your emotional strength to deal with the ups and downs of the market.  Even retirees who draw their current income from their investments should have a portion of their savings invested in stocks so that their money will grow faster than inflation.

To be a savvy investor, know the difference between investing and speculating.

Investing for the long run

Stock Course

Stocks 103: Investing for the long run

Over time, the rewards of investing in stocks outweigh the risks.

[Related content: stocks, stock market, investing strategy, shorting, investments]

By Morningstar.com

In the lesson Stocks 102, we noticed that the difference of only a few percentage points in investment returns or interest rates can have a huge impact on your future wealth. Therefore, in the long run, the rewards of investing in stocks can outweigh the risks. We'll examine this risk/reward dynamic in this lesson.

Volatility of single stocks

Individual stocks tend to have highly volatile prices, and the returns you might receive on any single stock may vary wildly. If you invest in the right stock, you could make bundles of money. For instance, Eaton Vance EV, an investment-management company, has had the best-performing stock for the last 25 years. If you had invested $10,000 in 1979 in Eaton Vance, assuming you had reinvested all dividends, your investment would have been worth $10.6 million by December 2004.

On the downside, since the returns on stock investments are not guaranteed, you risk losing everything on any given investment. There are hundreds of recent examples of dot-com investments that went bankrupt or are trading for a fraction of their former highs. Even established, well-known companies such as Enron, WorldCom, and Kmart filed for bankruptcy, and investors in these companies lost everything.

Morningstar.com's Investing Classroom

Between these two extremes is the daily, weekly, monthly, and yearly fluctuation of any given company's stock price. Most stocks won't double in the coming year, nor will many go to zero. But do consider that the average difference between the yearly high and low stock prices of the typical stock on the New York Stock Exchange is nearly 40%.

More from MSN Money and Morningstar
Stocks 104: What matters and what doesn't
Stocks 105: The purpose of a company
Stocks 106: Gathering relevant information
Stocks 107: Introduction to financial statements
MSN Money's New Investor Center

In addition to volatility, there is the risk that a single company's stock price may not increase significantly over time. In 1965, you could have purchased General Motors (GM) stock for $50 per share (split adjusted). In the following decades, though, this investment has only spun its wheels. By June 2008, your shares of General Motors would be worth only about $18 each. Though dividends would have provided some ease to the pain, General Motors' return has been terrible. You would have been better off if you had invested your money in a bank savings account instead of General Motors stock.

Clearly, if you put all of your eggs in a single basket, sometimes that basket may fail, breaking all the eggs. Other times, that basket will hold the equivalent of a winning lottery ticket.

Volatility of the stock market

One way of reducing the risk of investing in individual stocks is by holding a larger number of stocks in a portfolio. However, even a portfolio of stocks containing a wide variety of companies can fluctuate wildly. You may experience large losses over short periods. Market dips, sometimes significant, are simply part of investing in stocks.

For example, consider the Dow Jones Industrials Index, a basket of 30 of the most popular, and some of the best, companies in America. If during the last 100 years you had held an investment tracking the Dow, there would have been 10 different occasions when that investment would have lost 40% or more of its value.

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The yearly returns in the stock market also fluctuate dramatically. The highest one-year rate of return of 67% occurred in 1933, while the lowest one-year rate of return of negative 53% occurred in 1931. It should be obvious by now that stocks are volatile, and there is a significant risk if you cannot ride out market losses in the short term. But don't worry; there is a bright side to this story.

Over the long term, stocks are best

Despite all the short-term risks and volatility, stocks as a group have had the highest long-term returns of any investment type. This is an incredibly important fact! When the stock market has crashed, the market has always rebounded and gone on to new highs. Stocks have outperformed bonds on a total real return (after inflation) basis, on average. This holds true even after market peaks.
Continued: Best performers

Related content: stocks, stock market, investing strategy, shorting, investments]

If you had deplorable timing and invested $100 into the stock market during any of the seven major market peaks in the 20th century, that investment, over the next 10 years, would have been worth $125 after inflation, but it would have been worth only $107 had you invested in bonds, and $99 if you had purchased government Treasury bills. In other words, stocks have been the best-performing asset class over the long term, while government bonds, in these cases, have merely kept up with inflation.

This is the whole reason to go through the effort of investing in stocks. Again, even if you had invested in stocks at the highest peak in the market, your total after-inflation returns after 10 years would have been higher for stocks than either bonds or cash. Had you invested a little at a time, not just when stocks were expensive but also when they were cheap, your returns would have been much greater.

Time is on your side

Just as compound interest can dramatically grow your wealth over time, the longer you invest in stocks, the better off you will be. With time, your chances of making money increase, and the volatility of your returns decreases.

The average annual return for the S&P 500 stock index for a single year has ranged from negative 39% to positive 61%, while averaging 13.2%. Stocks held for five years have seen annualized returns ranging from negative 4% to positive 30% while averaging 11.9%.

These returns easily surpass those you can get from any of the other major types of investments. Again, as your holding period increases, the expected return variation decreases, and the likelihood for a positive return increases. This is why it is important to have a long-term investment horizon when you are getting started in stocks.

More from MSN Money and Morningstar
Stocks 104: What matters and what doesn't
Stocks 105: The purpose of a company
Stocks 106: Gathering relevant information
Stocks 107: Introduction to financial statements
MSN Money's New Investor Center

Why stocks perform the best

While historical results certainly offer insight into the types of returns to expect in the future, it is still important to ask the following questions: Why, exactly, have stocks been the best-performing asset class? And why should we expect those types of returns to continue? In other words, why should we expect history to repeat?

Quite simply, stocks allow investors to own companies that have the ability to create enormous economic value. Stock investors have full exposure to this upside. For instance, in 1985, would you have rather lent Microsoft money at a 6% interest rate, or would you have rather been an owner, seeing the value of your investment grow several-hundred fold?

Because of the risk, stock investors also require the largest return compared with other types of investors before they will give their money to companies to grow their businesses. More often than not, companies are able to generate enough value to cover this return demanded by their owners.

Meanwhile, bond investors do not reap the benefit of economic expansion to nearly as large a degree. When you buy a bond, the interest rate on the original investment will never increase. Your theoretical loan to Microsoft yielding 6% would have never yielded more than 6%, no matter how well the company did. Being an owner certainly exposes you to greater risk and volatility, but the sky is also the limit on the potential return.

The bottom line

While stocks make an attractive investment in the long run, stock returns are not guaranteed and tend to be volatile in the short term. Therefore, we do not recommend that you invest in stocks to achieve your short-term goals. For best results, you should invest in stocks only to meet long-term objectives that are at least five years away. And the longer you invest, the greater your chances of achieving the types of returns that make investing in stocks worthwhile.

Published Oct. 1, 2008
http://articles.moneycentral.msn.com/learn-how-to-invest/stocks-103-investing-for-the-long-run.aspx

Major types of Investments

Major types of Investments



Main types

1. Stocks or equities

2. Bonds or fixed income securities

3. Money market investments



Derivatives

1. Options

2. Futures



Unit trusts

1. Money market funds

2. Bond funds

3. Equity funds

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Bonds or fixed income securities

Bonds are loans issued by companies and governments to borrow money, and they have two main characteristics:

1. They have lifespan greater than 12 months at the time of issue.
2. They typically promise to make fixed interest payments according to a given schedule.

Bonds are hence also called fixed income securities.

Bonds have their own unique terms: Suppose you buy bonds with a face value of $10,000. These bonds mature in 2 years and pay 4% interest annually. The 4% interest equates to $400 a year. The face value of the bond, or the principal amount of $10,000 will be returned to you when the bond matures in 2 years.

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Money market securities

Money market securities are similar to bonds except that they are short-term investments. They have two main characteristics:

1. They are loans issued by companies and government to borrow money.
2. They mature in less than a year from the time they are sold, which means that the loan must be repaid within a year.

Some of the most common money market securities include

• Treasury Bills (issued by the government and considered the safest investments around),
• fixed deposits,
• bank savings accounts and
• certificates of deposits.

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