Hey!

In finance world, it is a commonplace knowledge that stocks (and bonds) are the best long-term investment vehicles for the “average” citizen [1]. By an “average” citizen, I mean you are not flipping houses or working on your own business. If you are doing either of this, kudos to you and keep doing it.

For the rest of us “average” citizens, stocks and bonds are the best building blocks for our investments. It is important that we clearly understand what they are and what are their characteristics.

In this post, I give an interesting introduction to stocks and bonds, peppered with historical tidbits. First, lets start with the credit markets.


Credit markets

Introduction

If the stocks and bonds are like candies that you want to buy, then credit market is the shop you go to buy it.

So what happens in a credit market?
In a credit market, the investor lends money to a borrower. Then, the borrowers use this money and, then returns the original money with an additional interest paid on top of it.

Why does anyone borrow money?
There could be various reasons. Maybe, someone needs to open up a new business, for which he needs some initial investment. For this a business owner can come to the credit market.
An ideal credit market is a win-win situation for both the lender and the borrower.

Historical

The credit markets are not new concepts. In fact, there are historical records of credit markets existing in ancient civilizations such as : Sumeria, Babylon and Assyria. There were comprehensive laws laid out to deal with transactions in ancient credit market.

Allow me to present one such well documented slice of history. Years ago, in Greece a “bottomry loan” was available in its credit market.  In this particular loan, money was lent by investors for maritime shipments from Greece to Bosphrous. If the voyage was successful, then the investors were paid back the original money with an additional interest. But if the vessel sank, the loan was forfeited i.e. no money was paid out (not even the original money).

In this specific Greece example, things gets even more interesting. The interest rate of the “bottomry loan” depended upon the time it was issued.

PeriodInterest rate
Peace time20%
War time30%

The reasoning was that during the war-time, the probability of a ship sinking was higher than during the peace time. Hence, the investors demanded more reward to compensate the higher risk of cargo loss. If the loan paid out the same interest during both the times, then nobody would be willing to invest during the war time.

20% interest was paid on the loan during peace time. The probability of ship sinking is low.
30% interest was paid on the loan during the war-time. The probability of ship sinking is high.

No guts, no glory

The earlier Greece example neatly leads up-to the most important lesson in financial investments. The lesson is that risk and reward of financial instruments are inextricably related.

“More potential risk implies more expected reward.”

Every investor, should always remember this. The more risk you are willing to take, the more returns you will get.

Another of one my favorite examples to further illustrate this point is the : investment returns in the ancient roman world. If you plot the prosperity of the roman civilization (vs) interest rate obtained on the roman investment, it would look like the following figure.

The investors who were willing to invest in less prosperous time (less sense of public trust and societal permanence) had a higher rate of return. As the civilization matured and stabilized, the interest rate slowly fell indicating the low risk nature of investments. At its glory and the apex of prosperity, the interest rate was as low as 4%.

In fact, the Austrian economist Eugen von Bohm stated that the cultural and political level of a nation could just be discerned by looking at its interest rate.

So, always remember the relation between risk and return. We will again come back to this in the next section.


Back to the present : Stocks and Bonds

As times have progressed, so have the financial credit markets. In the ancient times, it was difficult/impossible for an average citizen to buy investment vehicles. But we are in fortunate times, anyone can go to the credit markets and start buying easily. There are myriads of options to choose from. But, the fundamental building block of all these options are : Stocks and Bonds. So lets try to understand what do they mean.

Introduction

For the sake of simplicity, let me explain stocks and bonds with the help of an example.

First, meet mark. He has an incredible idea for a business.

 

Mark.

It’ll take a bit before Mark’s business starts making money. But from day one he will have expenses and so he needs money for that up front.

He can get this money from two ways. He can go to a credit market and then:

  1. Borrow money from people at a specific interest rate. He then promises to pay the borrowed principal money with the interest rate after a specific time period.
  2. Sell an ownership interest of his business in exchange for money.

It is not necessary that he needs to follow only one of the above two paths. He can do a combination of both1.

Next, meet Jim and Cindy. They both have heard about Mark’s business and they want to give him money. So they go to credit market to invest in Mark’s business.

Now, Jim follows the first path (see above) and “lends” money to mark. Jim is just a lender.
Whereas, Cindy takes the second path and buys an ownership interest in exchange for her money. She owns a piece of the company.

The credit market now enforces some conditions on Mark.

  • The first condition is that Mark should legally pay all Jim’s (lenders) interest and principal money first. Only after they have been paid, and only after other ongoing business expenses have been met, Mark can pay the remaining profits to Cindy (owners) of the company.
  • The second condition is that in case of bankruptcy, i.e. the company collapses, Jim (lenders) has the first claims on the assets of the bankrupt company.

Comparison

In finance parlance, it is said that Jim has bought a “bond” from Mark. Whereas, Cindy has bought a “share”.

If you have read the earlier conditions enforced by the credit market, you would have already made out that it is riskier to hold stocks of Mark’s company when compared to bonds.

So which do you think should provide higher returns?
You guessed it right! Yes, stocks will provide higher returns.

Stocks are a risky investment vehicle and so have higher returns. Vice-versa for bonds.

The owners of the stocks are willing to take considerable risks to get higher returns. The owners of the bond, who care about safety, are willing to live with lower returns.

In the earlier example, the best Jim can do is collect the interest payment and the principal money at the end of time period. It has a limited upside potential. Cindy represents a claim on all of the future earnings of company.

The growth of the company could explode by 1000 times. Cindy will have a piece of it, but Jim can’t. Cindy has an unlimited upside potential.

Also, in the earlier example I used Mark. But companies, corporations and governments can also issue stocks and bonds to raise money.

Here are some real numbers of risk vs return for you. The historical returns and risks of US stocks and bonds in 20th century is shown in the following table2.

AssetAnnualized returnWorst three year loss
Treasury bonds5%-25%
Large company stocks10%-60%
Small company stocks12%-70%

So, I hope you have a fair idea of what stocks and bonds are now. They are at the two ends of the risk vs return spectrum. All the points that were discussed above is summarized in the following table.

 Stocks Bonds
DescriptionHas an ownership interest of the companyLender to the company
The money is paidLastFirst
BankruptcyLast claimFirst claim
Upside potentialUnlimitedLimited
RiskHighLow
ReturnHigh Low

So where should you invest: Stocks or bonds?

The short answer is both. The long answer is – it is complicated. It depends upon various factors such as your risk tolerance, your time in the market and other such things. It is a separate post in itself. I am planning to write a post soon on this. So, please keep watching this blog. Or even better SUBSCRIBE  here and I will notify you via email.


Conclusion

  • Credit markets have been in existence for a long time.
  • The historical records indicate that the risk and reward of investments are inextricable intertwined.
  • Do not expect high returns without high risk and vice-versa.
  • Stocks and bonds are the best investment tools for an average investor.
  • Stocks are high risk-high return.
  • Bonds are low risk-low return.
  • Optimally invest in both. How? That post is coming soon – SUBSCRIBE.

Questions? Leave me a comment or contact me, I would be happy to help.
Also, if you find this helpful, please share it to your friends and family. More audience encourages me to keep writing such useful content. Thanks folks.
Until the next time, Ciao!


If you liked this, you might also like:

  1. Why should you start investing?
  2. When can you attain financial independence?
  3. Theory of investing Part 1: Stocks and Bonds
  4. Index funds : The only investment guide that you need to read
  5. What kind of investor are you : Defensive or Enterprising?

Theory of investing Part 1: Stocks and Bonds

3 thoughts on “Theory of investing Part 1: Stocks and Bonds

  • February 20, 2017 at 19:41
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    Hi, thanks for sharing your knowledge!
    Just stumbled upon your blog and I find it very easy to understand and useful.
    I’ll gladly share it with my friends for its simplicity. Keep up the good work and I just can’t wait to read your next posts!
    p.s. remember goal 4, there is still some time left for February 🙂

    Reply
    • February 21, 2017 at 09:17
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      Hi Dorian,
      Thank you for the kind words. Yes, please do share it. More the merrier!
      This was exactly the kick I needed for February, so thanks 🙂 !
      I promise to write one more useful post.

      Best,
      Adi

      Reply
  • August 8, 2017 at 20:23
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    Hi Adi,

    I was trying to understand these concepts since long time. Finally got to read this wonderful and easily appreciable stuff. Have clear understanding now. Thanks for sharing !
    Waiting for your theory on “where should you invest: Stocks or bonds?”

    Reply

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