Welcome back to the second installment of our “What is…?” series. Last month we took a look at cash, and the role we believe it should play in your investments. Yes, it is now September, yes summer is almost over, no we don’t blame you if you’ve forgotten last month’s note. Feel free to read over it again and refresh your memory.
This month we are going to look at “securities” - specifically stocks and bonds. Now, the term securities is fairly broad and encompasses basically anything you can or could buy and sell in a financial market. Mortgage-backed securities (MBS) were all the rage a decade ago. As were other acronymed things like CDS and CDO. We considered giving in-depth explanations on these, but feel that by and large Margot Robbie has it covered, so suffice it to say that securities can be almost anything.
The two most common types of securities, and what most people are usually referring to when they talk about investing (us included), are stocks and bonds. So let’s start with what exactly these things are that you may be buying, and how they end up in your portfolio they way they do.
Have your red pill ready? Good. Let’s go.
Stocks, also referred to as “equity”, are shares of ownership in a company. If you own the stock, you are considered a “shareholder”. These used to be issued as actual stock certificates - really decorative pieces of paper certifying shares of ownership of a company.
The value of a stock is tied to the value of the company. If you think that statement is fairly tautological, you are correct. The trick is in figuring out exactly what that value is...and then making an assessment of whether it’s fairly valued, undervalued, or overvalued. We will not be addressing the merits of any particular valuation technique in this letter - stock price valuation is it’s own discipline, complete with competing schools of thought, academic textbooks, and more how-to guides in your local Barnes & Noble than you can shake a stick at. All we want to do right now is address what a stock is. And what a stock is is essentially a claim on future profits of a company.
If we buy a stock, we expect to make money in two ways. One is by collecting a dividend. Every quarter, most companies will give some money back to their shareholders in the form of a dividend. Right now, the average dividend on the S&P 500 (the largest companies in the US) is about 2%. So if the stock price never moves from the level at which you bought it, you will still make 2% a year. But! We also expect the stock price to move. As a company grows and becomes more profitable, the stock price will go up.
Simple, fictional example (any resemblance to actual real life is purely incidental): let’s say Pokemon, Inc. is a company. They make this game that was really big about two decades ago and are surviving on Saturday morning Cartoon Network reruns and limited edition trading card packs for anybody who still plays their card game. Let’s say they’re worth $10,000,000 as a company, and say there are 1,000,000 shares of Pokemon, Inc. stock out in the world, so very simplistically each share is worth $10. If Pokemon, Inc. releases a new game...one that can be played on your phone...one that everybody in the world plays for six months, and makes a boatload of money on said game, then maybe they’re worth $50,000,000 as a company now. There are still only 1,000,000 shares of stock outstanding, so the stock price has risen from $10 to $50. Not bad.
We’re not saying you should expect your stocks to quintuple overnight. But we are saying that growth in a company over time will cause the stock price to go up, and along with dividends that is how you make money by investing in stocks.
Bonds, also referred to as “fixed income”, are debt. All bonds have a couple characteristics in common: a maturity date and an interest rate. They are essentially IOUs - promises to pay you back in the future, and in the meantime will pay you some interest rate for the use of your money. These also used to be issued as certificates, with little coupons that you would clip off every six months and turn in for your interest payment.
The interest rate you get paid varies depending on a number of factors, but the big ones are how risky the company is and how long before they promise to pay your money back. The way you make money on bonds is by collecting the interest payments (still often referred to as a coupon). Say you pay $1,000 for a 5% bond that matures in 5 years. You will get $50 every year for five years, and then in addition you will get your original $1,000 back. Very similar to collecting the dividend from a stock, if the stock price never moved.
Fairly straightforward, right? With a little intuition you can now explain basically everything about investment portfolio construction for 90% of advisors out there:
Return: Stocks have a higher potential for growth than bonds, because you are linked to the growth of the company. With bonds, you just get your original money back at maturity. No growth in that.
Risk: But, stocks are also riskier. Company profits can go down, for any number of reasons, which will cause a company’s stock price to go lower. So if you bought stock at $10 and now it’s at $8...sorry, you just lost 20%. With bonds, however, as long as the company is still in business, you should expect to get paid in full when the bond matures...even if the stock price is lower.
And this leads to nice little pie charts like the ones below, with a series of portfolios based on your age and with different names like “conservative”, “aggressive”, “moderately conservative”. It’s almost like boxing a compass. It wouldn’t surprise us at all if ”moderately moderately conservative” or “moderately aggressive by balanced” were out there somewhere...
If you’re young and/or wanting your money to grow and/or not needing it for a while, sure, load up on stocks. Higher growth potential. If you’re retired and have a decent amount of money saved up, why risk it? Put it in bonds and just live off the interest you’ll get paid.
Now, imagine those two scenarios as the ends of a spectrum. The middle of the spectrum is filled will all the different percentage stock/bond combinations within a portfolio. Where you get placed on the spectrum is a function of age, investment goals, how long you’ll have your money invested, and your “risk tolerance” - based on answering a couple of questions about whether or not you’d be concerned to look at your portfolio and see that it has lost money (clearly that doesn’t evoke a warm and fuzzy feeling).
Since most people don’t like to think of their account losing any money ever, and most people also don’t like the idea of their account not making any money ever, pretty much everyone ends up somewhere in the middle - this “60/40” portfolio that is some version of a “balanced” or “growth and income” model. Get a little bit of growth from the 60% equities, get a little bit of safety and income from the 40% bonds, talk about long-term time horizons, buy-and-hold investing, and call it a day.
If you’ve been with us for more than a hot second, you’ll know that we take issue with...most of those viewpoints.
We feel it’s more than a little reductive to reduce people to a number, assume they’re just like everyone else with that same number, and invest based on that. Yes, that makes it a lot easier for most financial service companies to do business, but is it really what’s best for you? Wouldn’t it make more sense to first figure out what your money needs to do for you? What you want it to do for you? We believe that investing is a very personal process that should start with planning and a thorough understanding of your investment goals, rather than some blanket assumptions.
The other big issue we have is that, well, valuations matter. So those return assumptions for stocks and bonds, for a 60/40 portfolio based on long-term averages...that’s almost an arbitrary number. There is no guarantee you should even expect to get the long-term average in your investing lifetime, much less actually get it.
Stocks are a claim on future earnings of a company. Therefore, stock price is based on expectations of what those future earnings will be and how quickly they will grow. What happens if those expectations turn out to be a little rosy? Well, then your returns are less than expected as well. Bonds have similar valuation issues, but based around interest rate levels instead of company earnings (unless the company might go bankrupt).
We are currently in an environment where valuations don’t look great anywhere. Almost a decade of zero interest rate monetary policies has caused the price of stocks and bonds to go way up. Our expectation is that a 60/40 portfolio will return about 2% or so on average for the next decade based on current levels. So if you just buy your 60/40 portfolio and hold it for 10 years...congratulations on your 2% returns. You could have done almost as well by keeping your money in a bank CD risk-free (Not all banks. But there are some that offer 1.2% or more on an FDIC-insured CD).
Our preferred approach is to examine the market as it currently is at any given time. Rather than build a static portfolio that combines elements of growth and income into something that kind of sort of performs alright most of the time, we prefer to be invested in stocks when it looks like expectations for growth (and therefore stock market appreciation) are on the rise, and in bonds when it looks like those expectations are falling (as a way to try and minimize losses in the stock market).
We’re not saying a buy-and-hold approach is wrong. We’re just saying it doesn’t make sense to us right now, and you can probably do better. And, hopefully, now you understand a little bit more about why that is as well.
Alright, there's the bell. School's out, enjoy the long weekend.
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