A Common Sense Guide to Investing in Stocks and Bonds, Part 1: Economics of Stocks.
Stocks and bonds are very effective tools to grow and manage wealth. You can combine stocks and bonds to help you save for virtually any goal, from growing a nest egg for retirement to saving for college education, to a safety net. In practice, however, many people don’t have the confidence needed to select stock and bond investments. In addition, they may have had bad past experiences, particularly with stocks. The difficulty in selecting portfolios of stocks and bonds, combined with individual biases and past experiences, causes many people to hold suboptimal investments or others to avoid stocks and bonds altogether, to the detriment of their financial plans.
If you have felt like one of those investors before, we have good news for you. It turns out that a few basic principles grounded on economics and data can help us make sense of stocks and bonds, and guide us in making better decisions with our savings. We start with stocks this week, so follow us to learn more about bonds and how to put your investment portfolios together in future posts.
Stocks vs Bonds
When you buy stocks, you buy a small piece of the corporations that issued them. Therefore, with stocks you have a claim to a company’s current and future profits, after costs and other obligations have been paid. Bonds are a promise to make payments back at specific times in the future, and typically include semi-annual payments and a repayment of principal (the amount invested) at the end of the term of the bond (which can be up to 30 years). Both governments (from local to federal) and corporations issue bonds.
Generally, neither bonds nor stocks guarantee investors that they will get back the money they invested. However, because bonds are typically issued by governments with tax powers or more mature companies, bond repayments are relatively more predictable. In contrast, because a company’s future profits can vary unpredictably over time, the amount that can be returned to stockholders is much less predictable. If a company issues both bonds and stocks, payments to bondholders have priority over payments to stockholders.
Present Values and Stock Prices
Many goods and services that we consume provide us with value over time, including cars, clothes, watches, our home, and many others. Their market value depends on the total value or benefit they will provide over time. Compare two identical houses in the same location, one with a brand new AC system and one with a 10-year-old system that works great today. Both houses can provide you with the same benefits, today. However, the house with the brand new system will be worth more because it can provide air conditioning for many more years to come. The market value of the house represents the present value of all future benefits, net of future costs.
The same concept applies to businesses. The value of a business depends on the total amount of profits that it will be able to generate over time. Therefore, the stock price of a company reflects the present value of all the profits that the market believes the company can generate in the future. Even a company with no profits today can have a positive present value, if investors in the stock market believe the company will generate profits in the future. For example, Amazon was founded in 1994, and had no profits until 2001. However, a share sold for $18 when it went public in 1997. Over time, the value of Amazon has changed to reflect investor’s expectations of its ability to generate future profits.
Uncertainty and Risk
The idea that the market value of a business is the present value of future profits helps us understand why stock prices fluctuate so much. Future profits are hard to predict, even for large, established companies, let alone smaller ones. Profits depend on many factors, including the overall state of the economy, the amount of competition, technological factors that may make a product obsolete, government intervention, the weather, pandemics, and many other factors. As all these factors change over time, so does the market view of a company’s future profits. If we think about it this way, it’s no surprise that stock prices change so much over time.
The degree of fluctuations is such that some companies experience exceptional growth (Amazon, Google, Apple, 3M, Coca Cola, etc.), while others succumb after a few years. Research shows that the average company is listed on the NYSE for about 7 and a half years. Unfortunately, you can’t know ahead of time which companies will survive and prosper and which ones won’t. This makes investing in single stocks very risky. But should this surprise us? Not really. Estimates of the median life of any business are of similar length of time.
The lesson here is that while stocks attract a lot of attention and feelings of both greed and fear, common sense and economics can go a long way in explaining what we see in stock markets. We should not be afraid to invest in stocks any more than we are investing in any business or investment property. If anything, financial markets make it easier to invest in stocks relative to other alternatives.
Risk and Return
The good news about stocks is that bearing the uncertainty that comes with stocks has benefited investors historically. While stock prices fluctuate over time, they also tend to grow. After all, who would invest in a risky investment without the potential of future returns?
The growth potential of stocks is easy to understand in the Amazon case by comparing the stock price at the end of 2000 with the price in 1997. Even though there were no actual profits in either year, the company was worth much more in 2000. Not only the profits that were expected in 1997 started to look much more real, but by the year 2000 investors expected even higher future profits from Amazon.
Amazon is a particular case that has experienced exceptional growth, both in value and in actual profits. But the idea applies generally to stocks. As the general economy grows and brings a general increase in profits, we expect stock prices to increase in value. Historically, stock returns, including dividend payments and stock price appreciation, have been positive over long periods of time in the US and globally. For example, the US stock market has delivered annualized returns of over 10% between 1926 and 2019, as measured by the S&P 500 index, an index of the current 500 largest corporations traded in the US. A dollar invested in the S&P 500 in 1926 would be worth $9,237 today!
Growth of the S&P 500 Index (1926-2020)
This is a hypothetical scenario for illustration only. Data Source: Dimensional Fund Advisors.
The high average returns did not come without risk. There have been relatively long periods of negative or very low growth, most notably during and in the aftermath of the Great Depression (1929-1941), and in the decade 2000-2009. The high average return on stocks is earned on average and over time for bearing periods of low returns.
A Key Point: It is important to realize that the S&P 500 contains the largest 500 companies at a point in time. The companies that make the index in 2000 are different from the ones in 2020, although some do overlap. Many companies are added and many drop out over time as some grow to become the next Amazon while others may not grow or even fail and get delisted. The returns you see in the chart above are obtained by buying all of the companies, the ones that grow, and the ones that fail. The chart shows that you don’t have to be good at picking stocks or have a crystal ball to realize handsome returns if you are a long-term investor.
What’s a Market Index?
The S&P 500 is a “market-weighted” index of the 500 largest companies in the US by market value. It represents the returns of a hypothetical portfolio that invests in the 500 largest companies in the US, where companies are assigned a weight proportional to their market value. So if company A is twice the market value of company B, the index gives twice the weight to company A relative to B. This means that the returns on the index are equivalent to the returns of a hypothetical investment that purchased the 500 companies in their entirety. It turns out that the 500 largest companies represent about 85% of the total value of the US stock market. That’s why an index like this is often called a market index. There are other indexes besides the S&P 500, and we will review some of the most common ones in a future post.
These basic facts and principles can go a long way in getting us started with investing in stocks. How many stocks should you own in your portfolio? What is the most effective way to do that? Stay tuned for part 2 of our guide to find out.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
