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Investing, and exploring the risks or rewards of stocks/bonds

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Investing, and exploring the risks or rewards of stocks/bonds

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By Chey Lyle

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Welcome to investing with stocks and bonds, today we will learn some disadvantages and advantages of investing, and with bonds or stock.

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Welcome to investing with stocks and bonds, today we will learn some disadvantages and advantages of investing, and with bonds or stock.

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This is what a premium bond looks like in Canada when you would go to buy one for yourself.

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Here are what stocks look like, just a bunch of numbers. Green is for positive and red is negative money.

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Some advantages of stocks on the left side while on the right is what bonds can do to benefit you.

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When you hear bonds, you think it is all safe since you are lending money out, but with some types of bonds like lending the government money you know you will get the money back but then you have the small business that get shut down you do not get your money back or the interest you might have wanted for profit.

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3 Ways Bonds Can Be Riskier Than You Think

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Bond investors should understand the basics of interest rate risk, credit risk, and inflation risk, and why they matter for retirees.

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Stocks are an unit of ownership in a company that have primary and secondary marketing, with stocks the better the company does the more the reward is. Although, if the company starts going under while you are invested with them, your return will turn out being not so good or even none. In the long run if you think a company will do well in the future I would highly suggest getting some stocks in it.

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Understanding stock markets 101 | learn stock trading

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Stocks are almost always a better way to invest if you want profit. Think of it this way, a bond is a loan that the owner of the company must pay you back on a fixed interest rate, while a stock is determined by how well the company is doing. I'm sure you have heard the term the more risky the better the outcome, well that works for here as well.

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"Stocks provide greater return potential than bonds, but with greater volatility along the way." You have probably heard that statement so many times that you simply accept it as a given. But have you ever stopped to ask why? Why have stocks historically produced higher returns than bonds? Why are bonds typically less volatile? Understanding the reasons behind these trends could help you become a better investor. (For background reading, see " Equity Premiums: Looking Back and Looking Ahead.")

A Basic Example

Imagine that you are starting up a business. You are the sole owner and the only employee. It will take $2,000 to commence operations and you only have $1,000, so you borrow the other $1,000 from a friend, promising to pay that friend $100 per year for the next 10 years, at which time you will repay the original $1,000 loan amount. The first year, after all expenses have been paid, including your own salary, you find that your business has earned $500. You pay your friend the $100 promised and keep the remaining $400. Your friend has earned 10% (100 ÷ 1000) on his loan to you, but you have earned 40% (400 ÷ 1,000) on your investment.

The next year does not go as well and after all expenses have been paid you find that the business has only earned $100. You pay that $100 to your friend, who has again experienced a 10% return. You on, the other hand, are left with a 0% return, although your two-year return is still around 20% per year. And so it goes.

With each year, you have the opportunity to earn more or less than the friend who loaned you funds. If the business becomes wildly successful, your return will be exponentially higher than your friend's; if things fall apart, you may lose everything. The loan is a contractual arrangement, so if you have to close up shop, whatever money may be left goes to your friend before it goes to you. As such, your position involves greater risk, but with the opportunity of greater return. If there was no possibility of greater return, there would be no reason for you to take the greater risk.

More Risk, More Return

Let's relate our example stocks and bonds in the real world. Bonds are essentially loans: Like your friend above, investors loan funds to companies or governments in exchange for a bond that guarantees a fixed return and a promise to repay the original loan amount, known as the principal, at some point in the future.

Stocks are, in essence, partial ownership rights in the company that entitle the stockholder to share in theearnings that may occur and accrue. Some of these earnings may be paid out immediately in the form of dividends, while the rest of the earnings will be retained. These retained earnings may be used to expand operations or build a larger infrastructure, giving the company the ability to generate even greater future earnings. Other retained earnings may be held for future uses like buying back company stock or making strategic acquisitions of other companies. Regardless of the use, if the earnings continue to rise, the price of the stock will normally rise as well. (For related reading, see " Knowing Your Rights As a Shareholder.")

Stocks have historically delivered higher returns than bonds because, as in the simplified example above, there is a greater risk that, if the company fails, all of the stockholders' investment will be lost. On the flip side, however, there is a return to stockholders that could potentially dwarf what they could earn investing in bonds. Stock investors will judge the amount they are willing to pay for a share of stock based on the perceived risk and the expected return potential - a return potential that is driven by earnings growth. Being predominantly rational as a group, they will calibrate their investments in a manner that properly compensates them for the excess risk they are taking.

The Causes of Volatility

If a bond pays a known, fixed rate of return, what causes it to fluctuate in value? Several interrelated factors influence volatility:

Inflation and the Time Value of Money
The first factor is expected inflation. The lower/higher the inflation expectation, the lower/higher the return or yield bond buyers will demand. This is because of a concept known as the time value of money, which revolves around the realization that a dollar in the future will buy less than a dollar today because its value is eroded over time by inflation. To determine the value of that future dollar in today's terms, you have to discount its value back over time at some rate. (For more insight, read " Understanding the Time Value of Money.")

Discount Rates and Present Value
To calculate the present value of a particular bond, therefore, you must discount the future payments from the bond, both in the form of interest payments and return of principal. The higher the expected inflation, the higher the discount rate that must be used and thus the lower the present value. In addition, the farther out the payment, the longer the discount rate is applied, resulting in a lower present value. Bond payments may be fixed and known, but the constantly changing interest-rate environment subjects their payment streams to a constantly changing discount rate and thus a constantly fluctuating present value. Because the original payment stream of the bond is fixed, the changing bond price will change its current effective yield. As the bond price falls, the effective yield rises; as the bond price rises, the effective yield falls.

The discount rate used is not just a function of inflation expectations. Any risk that the bond issuer may default (fail to make interest payments or return the principal) will call for an increase in the discount rate applied, which will impact the bond's current value. Discount rates are subjective, meaning different investors will be using different rates depending on their own inflation expectations and their own risk assessment. The present value of the bond is the consensus of all these different calculations.

The return from bonds is typically fixed and known, but what is the return from stocks? In its purest form, the relevant return from stocks is known as free cash flow, but in practice the market tends to focus on reported earnings. These earnings are unknown and variable. They may grow quickly or slowly, not at all, or even shrink or go negative.

To calculate the present value, you have to make a best guess as to what those future earnings will be. To make matters more difficult, these earnings do not have a fixed lifespan. They may continue for decades and decades. To this ever-changing expected return flow, you are applying an ever-changing discount rate. Stock prices are more volatile than bond prices because calculating the present value involves two constantly changing factors: the earnings stream and the discount rate. (To learn more, read " Anything but Ordinary: Calculating the Present and Future Value of Annuities.")

The Bottom Line

The pricing of all the thousands and thousands of stocks and bonds is essentially rational. Market participants apply their cumulative knowledge and best estimates as to future inflation, future risks and known or unknown income streams to arrive at present-day valuations. These valuations are constantly fluctuating based on continually changing expectations. In hindsight, one can see that emotions, even in the aggregate, can cause these expectations, and thus valuations, to be incorrect. For the most part, however, they are correct based on what is known at any given point in time.

Bonds will always be less volatile on average than stocks because more is known and certain about their income flow. More unknowns surround the performance of stocks, which increases their risk factor - and their volatility. They have the potential to generate greater returns than bonds, and over time have generally done so. But always remember that along with the potential for greater gain goes the potential for greater pain, too.

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"Stocks provide greater return potential than bonds, but with greater volatility along the way." You have probably heard that statement so many times that you simply accept it as a given. But have you ever stopped to ask why? Why have stocks historically produced higher returns than bonds?

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Bonds are not always the safest bet to consider, let's say you $20,000 bond with 5% interest on it. Every year you would be getting $1000 in returns from the bond, but if the interest goes higher to 6% your current bond is not worth the $20,000 due to the fact that they are not making the 6% interest because it is fixed to your 5%. Now you can avoid all of this with maturing your bond but that may take a long time to get.

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Dave Explains Why He Doesn't Recommend Bonds

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There are a couple different types of stocks, but for basics let's just stick to single stocks and mutual funds. Single stocks are the riskiest type of stocks considering it is only on one single company, meanwhile mutual funds can be any number of company's split up from around 90-200. If one of the mutual funds crashes it might not matter due to the fact you have others to fall on since your stocks are split up unlike single stocks.

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The #1 Reason Single Stocks Are Dangerous

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Investing isn't just about the money, think of investing as giving a company or place to afford or help them out with something they wouldn't have had. For example, if you invest in a school you are not just making money, but you are helping the school be able to keep the maintain and needs for students. Maybe even encourage some to do bigger things. Now a day the average houses and living essentials have risen to a point that not everyone is going to be set with just a pension, if you want to live nice and have that gold watch when you retire I would advice you start to invest now.

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The Importance of Investment | Thomas Rider | TEDxDhahranHighSchool