Understanding the Basics
All investments have two primary characteristics that aggregate to the total financial gain derived for their investors, the income earned (distributions to investors) and the appreciation of the asset (capital gains). Stocks and bonds are two fundamental investment options that operate differently but serve as cornerstones of financial markets. Stocks represent ownership in a company, giving investors a claim on its earnings and assets which may also come in the form of small business assets. Bonds, on the other hand, are essentially loans made by investors to corporations or governments, in exchange for periodic interest payments and the return of principal at maturity, not dissimilar to the auto loans or mortgage you pay to the bank for a defined period. The former typically delivers higher capital appreciation and the latter has a higher emphasis on income.
Understanding these basics enables investors to make more informed decisions. Stocks offer potential for high returns but come with increased risk due to market volatility. Bonds provide more stability and steady income, making them a steadier investment choice.
The not so boring side of bonds
Bonds are considered a safer investment compared to stocks. They provide fixed interest payments over a specified period, making them an attractive option for risk-averse investors. The bond market is influenced by factors such as interest rates, inflation, and credit ratings.
When interest rates rise, bond prices typically fall. This inverse relationship happens because new bonds are issued with higher yields, making existing lower-yield bonds less attractive. Conversely, when interest rates decline, existing bonds with higher yields become more valuable.
Understanding bond ratings is also essential. Ratings assess the creditworthiness of the bond issuer. High-rated bonds (AAA) are less risky but offer lower returns, while lower-rated bonds (junk bonds) provide higher yields but come with increased risk. The same way a lower credit score leads to higher rates on car loans and mortgages for individuals, so too, does it lead to higher bond interest payments when being lent out by investors!
Stocks summarized
Stocks represent ownership in a company and offer the potential for capital appreciation and dividends. The stock market is driven by supply and demand, influenced by various factors such as company performance, economic conditions, and investor sentiment.
Stocks are more volatile than bonds due to their sensitivity to market conditions. Factors like earnings reports, geopolitical events, and changes in interest rates can cause significant price fluctuations. In exchange for this volatility, investors have been rewarded that diversify their stock holdings across different geographies, sizes & sectors to mitigate risk. While concentration can more quickly build or destroy wealth, Harry Markowitz, Nobel Prize laureate, stated that “diversification is the only free lunch” in investing in order to help maximize investors' risk-adjusted returns over time. Said another way, while anyone can get lucky with the right time to buy in crypto or penny stocks, seldom is that ever possible repeatedly over the long term.
Nerd Note: The 2000’s were termed as the “lost decade” in US investments, where the average investor would have been considered lucky to leave that decade with more in their portfolio than when they started. While many may be enamored with the performance of the broader stock market in the preceding decade, it is often forgotten that there may be long stretches of unfavorable performance that would be a boon to young investors that save, but represent larger risks for those closer towards needing to withdraw.
The Art of Staying Invested
Staying invested in the market requires discipline and a long-term perspective, but it takes a heck a lot of intestinal fortitude to run towards the equivalent of a burning building of a market than away from, especially when our life's savings are on the line. These are, however, the times where investors make the best or worst long term investment decisions.
Historical data shows that the stock market has generally trended upwards over the long term, despite short-term downturns. Believers in the market are believers in the future productivity and ingenuity of the society they’re investing in and have been handsomely rewarded over time, contrary to what the never ending flashing red headlines the market’s talking heads may cause you to believe.
Investors who remain patient and avoid panic selling during market declines are more likely to achieve their financial goals. This is much easier done when a well-thought-out investment plan is in place.
Stocks in the trenches
An analysis of the broader US stock market from 1980-2022 helps us envision what is “normal”.
On average, investors in the US stock market experience a drop of ~14% during any given year from the high, for this volatility and risk, they have been rewarded with a double digit return.
Nerd Note: Historically the highest highs and lowest lows of stock market cycles run an average of 5-7 years. This helps underscore that if you may need your investments for anything within the next 7 years, you should strongly consider how you allocate your assets.
The Bond Centerboard
Bonds serve as a protective shield in an investment portfolio. They provide stability and predictable income, offsetting the volatility of stocks. This balanced approach helps manage risk and preserves capital.
The safety of bonds lies in their fixed interest payments and principal repayment at maturity. Unlike stocks, bonds do not fluctuate as much in value, making them a dependable income source.
Investors should consider the duration (length of payment) and credit quality of bonds when adding them to their portfolios. Shorter-duration bonds are less sensitive to interest rate changes, while higher-quality bonds offer greater security.
Adopting a Long-term Investment Strategy
A long-term investment strategy involves holding assets for several years, allowing market cycles to unfold. Long-term investors benefit from “compound interest”, something Einstein once termed as the 8th wonder of the world, which significantly enhances returns over time.
Regular contributions to the investment portfolio along with the income from the portfolio, regardless of market conditions, helps build wealth steadily. This disciplined approach ensures consistent progress towards financial goals.
Time Tested Takeaways
Practical investment wisdom focuses on maintaining a diversified portfolio, staying informed, and avoiding emotional decisions. Diversification spreads risk and provides exposure to different asset classes.
Avoiding emotional decisions, such as panic selling during market downturns, is crucial. For existing investors, you were kept up at night as an investor through Covid, now would be a good time to revisit the risk you are taking. Conversely if you are fresh, taking inventory of what your near term needs may be will be an important way to ensure you are not a forced seller in the future by having a war-chest of safe funds in the form of bonds or an emergency fund available if need be.
The most savvy investors in the world recognize that they too, cannot predict the direction of the markets with consistency over a long period of time. For that reason, they aim to manage the risk they take by building in a margin of safety when they will need the funds. Benjamin Graham, who helped teach Warren Buffett, once said “the purpose of margin of safety is to render the forecast unnecessary”. If you or anyone you know is aiming to get ahead by timing their investments or believe they can outperform the markets from forecasts, it makes sense to take a long pause before making any decisions.
Emotional reactions can lead to significant losses and derail long-term investment plans.
Understanding the behavior of stocks and bonds equips investors with the knowledge to make informed decisions and ensure they are properly positioned well in advance of the market winds blowing. By balancing risk and reward, staying invested, and adopting a long-term strategy, investors can achieve their financial goals.