This past month the financial advisors at Ruedi Wealth Management began writing short “Investing 101” columns that appear every Sunday in the News-Gazette’s business extra section.
Make sure to look for them every Sunday, but in case you missed them this past month, below are the Investing 101 columns from April. We started off with Paul Jr. explaining what bonds are and Daniel explaining what stocks are.
What is a Bond?
By Paul R. Ruedi, CFP®
Bonds, in the simplest terms, are loans to companies and governments. They usually provide a series of fixed interest payments for a set period before returning the original amount the investor loaned, called principal. This is why they are often referred to as fixed income investments.
Bonds are issued by a variety of different borrowers to finance their activities. The 4 main types are:
1) Government Bonds – loans to the federal government. They are issued by the US Treasury which is why they are sometimes called “treasuries.”
2) Municipal Bonds – loans to states and municipalities. Some of these provide tax-free interest to investors.
3) Agency Bonds – issued by government-affiliated organizations like Fannie Mae and Freddie Mac.
4) Corporate Bonds – loans to individual companies.
There are two key features of bonds that determine the returns investors receive.
The first is the term of the bond - or length of time the money is loaned out for. Bonds are issued with a specific maturity date when an investor gets back the money they originally loaned. Generally speaking, the longer money is loaned out for, the higher the interest rate (except in rare cases when yield curves temporarily “invert”). Bonds with 6 months until maturity will generally offer lower returns than bonds with 5 or 10 years to maturity to compensate investors for loaning their money out for longer periods of time.
The second is credit quality of the bond – the riskiness of who is borrowing the money. Riskier companies and governments will generally have lower credit ratings and will have to offer higher interest rates to compensate investors for taking on greater risk. The highest risk “junk” bonds have to compensate investors even more, as they are issued by extremely risky borrowers.
Bonds, especially short-term and high-quality bonds, are attractive to investors because they are relatively low-risk investments that do not fluctuate very much in value relative to stocks. Of course, risk and return are related, so bonds have lower expected returns relative to stocks.
In a blended portfolio of stocks and bonds, bonds are best used as the stabilizing asset, serving to smooth out any short term drops in portfolio value that may be caused when the stock market declines.
Investors in bonds should diversify as much as possible by buying bonds from many different governments and companies to avoid putting too many of their eggs in any one basket.
What is a Stock?
By Daniel Ruedi, CFP®, RICP®
When a business needs to raise money, one of the ways it can do so is by selling fractional shares of ownership of the business itself. These fractional shares of ownership are called stocks, and provide their owners with a claim on a portion of the profits of the business.
Stocks are initially sold to the public through Initial Public Offerings (IPOs), after which point they are bought and sold on exchanges like the New York Stock Exchange or Nasdaq Stock Exchange. However, a typical stock investor will never need to visit one of these exchanges, as they can place orders for individual stocks online through a major broker like Schwab, E-trade, Fidelity, etc.
Stock ownership provides investors with the privilege of voting on management issues at shareholder meetings and a proportional share or dividends if they are paid. The corporation is treated as a separate entity from the shareholders, so if the corporation gets sued or goes bankrupt, the shareholders aren’t personally liable to repay the corporation's debts.
Stocks are attractive to people who are willing to take on the risk of owning a business or many businesses in order to grow their wealth. Over long periods of time, they are expected to provide higher returns than bonds or cash. The unpredictability of stock returns is likely the reason stocks have historically earned two to three times the return of bonds. When things go bad, investors who own the company’s bonds get paid before stock shareholders, who are last in line for any remaining proceeds.
Stocks provide returns to investors in two forms. The first is dividends, payments from the company to stock owners. The second is capital appreciation, the increase in the price of the stock over time.
When the profits of a company rise, or are expected to rise, a claim on future profits becomes more valuable, and the stock price increases. In this way stocks can provide a return to investors even if they don’t pay out any actual cash dividends.
But, as you may have guessed, any bad news that would cause investors to become pessimistic about the future profits of a company will cause the price of a stock to fall.
As new information is constantly becoming available, stock prices bounce around a lot, and can fall rapidly in short periods of time. For this reason, owning stocks is best suited for people who are investing for long periods of time and can emotionally handle large swings in the value of their investment portfolio. If you don't plan on owning stocks for a minimum of five years and cannot stomach a 50% temporary decline, you might want to invest elsewhere.