Although the time to buy stocks and bonds depends on interest rates, the methodology for making your selection is quite different. I often tell students that if investments were like high school students, I would like my bonds to be B / C students and my stocks to be outstanding students. So what does that mean?
Straight A’s – Stock Purchase
When looking at the risk of owning stocks, we must always remember that common shareholders are the last priority to receive payment for failed securities. If you own shares in a company and go through tough times and eventually declare bankruptcy, chances are you will lose every penny you invest. You see, when a company goes through the liquidation process, the capital that remains in the business is distributed in a certain order. This order is:
3. Preferred shares
4. Common shares.
By owning a business that is highly leveraged, the chances of the business going bankrupt are greatly increased. If such an event occurs, most of the remaining capital will be used to repay investments to bank loans and bondholders. In most cases, these holders keep losing money. As you can see, ownership of a common stock requires a tremendous amount of confidence in the ability of companies to maintain operations during difficult times. Think of it from this perspective. Is it easier for a person to increase wealth and avoid slow financial growth by avoiding debt? The answer to that question is obvious: yes. Well, owning shares in a company is no different. Avoiding companies that are heavily in debt often leads to profitable returns.
Students B / C – Purchase of bonds
When a person goes to the bank to buy a house, they often get different interest rates than other customers. The reason is directly related to the risk of the borrower. When companies issue bonds, they experience the same with investors. If the business is not stable and may experience tough times for years to come, investors will demand a higher return on their money. So how much of a return is a good return while still considering risk? Well, this is a very important question to answer.
When we were dealing with stocks, the future returns of the business were directly related to the ability of the company to grow its profits and increase its market share. With bonds, the only thing that matters to us is the company’s ability to pay its debts. In the end, I don’t care if the company’s product is successful in the long run. I just want to know if the product is successful enough for the company to continue operating. As a student, I only care if they pass. If they do, they stay at the school to fight for another day.
You see, investors in stocks are rewarded for exceptional performance. Bond investors are rewarded for possessing security that is good enough to continue trading. Although this mindset may sound cheeky, it’s the only way you’ll be able to align your risk versus reward assessment for two very different types of securities.