Investing Basics: Stocks and Bonds 101

Everyone has heard of stocks and bonds, but most people do not know how they work. This article will give you a basic understanding of what stocks and bonds are, how they work, and why people invest in them. This article may be rudimentary for some readers. Still, this article will open the understanding and a world of opportunities for others. 

Companies have a few legal ways of raising capital (money): owners contributing money, companies selling or borrowing something. Stocks are the selling option, and bonds are the borrowing option. 

Stocks

When you buy a stock, you buy a small piece of the company. The term is “shares.” If the company sells 10,000 shares and you buy one share, you own 1/10,000 of the company. As an owner, you should be entitled to 1/10,000th of the profits. People make money with stocks in two main ways: price appreciation and dividends. Usually, shareholders get paid profits in dividends, but only some companies pay dividends. Several stock pricing models exist, but all the different pricing equations try to give a value for future earnings. 

Most people invest, hoping the value will grow over time. Some typical trading advice is “buy the rumor, sell the news.” This strategy works reasonably consistently because the rumor creates a price increase as investors expect higher future earnings. There may be a rumor that the new widget or process will revolutionize an industry. Investors get excited, and the rumor gets the price moving. However, the news is usually underwhelming, and the price falls. The price rose and fell because of expectations of future earnings.

The SEC requires four earnings reports annually, three quarterly reports, and one annual report. It is common to hear the commentator say, "X Company missed earnings" or "X company exceeded earnings." Since stock valuations are based on future earnings, the reports are essential for an accurate price. Most of the time, the stock price goes down when a company "misses" earnings. If the company "misses" earnings, the market has been paying too much for the company. If the company "exceeds" earnings, the market has undervalued it, and a price jump usually happens. In a recession, the price of stocks tends to march downward over time. Although a recession is a sustained period of negative growth seen by looking backward, it is a statement from the market that the worst is still to come. A down market is saying the expectation is that earnings will be smaller in the future.

Since stock prices are an educated guess about what will happen in the future, stocks are considered speculative. A common term is “risk on” asset. Stocks can be risky, so most financial advisors recommend rebalancing a portfolio from a “risk on” asset class, like stocks, to a less risky bond position.

Bonds

When you purchase a bond, you are loaning money to the company. There is a contract, and the company pays back a specified amount quarterly, semi-annually, or annually. The rate the bond pays is called the “coupon  rate.” The most common payback is annual, but the payback period can vary. An investor buys a bond for a set time duration, like four or ten years. Annually, the investor will receive coupon payments. The coupon payment will be expressed as a percentage. If it is a $1,000 bond and the coupon rate is 5%, the coupon payment would be $50 annually. (.05 x $1,000=$50). The final coupon payment will also include the initial investment returned to the investor. In our example, the investor received a total of $200 in coupon payments. The graphic shows the cash flow of a bond.

In most markets, bonds tend to have less risk than stocks. Some people think less risk means no risk. Despite the popular misconception, bonds have risks.

In most markets, bonds tend to have less risk than stocks. Some people think less risk means no risk. Despite the popular misconception, bonds have risks.

The most significant risk is interest rates. The second biggest risk is whether the company or government will default on the loan. Interest rates affect bond prices and the expected coupon rate. It is relatively straightforward to see how interest rates affect coupon payments. A higher interest rate means a higher coupon payment. However, a higher interest rate is bad for bonds already purchased.

Suppose you bought a five-year bond paying a 5% coupon rate. After two years, a family emergency forced you to sell some assets. If you sell your bond, it would be like a three-year bond with a 5% coupon rate. Depending on how interest rates have moved determines your selling price. There are three possible circumstances: rates are the same, rates have gone up, or rates have gone down.

Scenario 1: Rates are the same. Scenario 1 is the most straightforward. The bond will sell at "par,” meaning face value.

Scenario 2: Rates have gone up. This is the worst-case scenario. You will have to sell your bond at a discount. Suppose the rates went up to 6.5%. No one will buy your 5% bond unless you discount the bond to give an equivalent yield. There are equations to determine the price and calculators designed for bond adjustments. In our scenario, you would sell your bond at $959.71. Although the interest rate only went up by 1.5%, you would need to sell at a -4.29% discount. If you sold after year 1, you would need to sell at a -5.21% discount. In other words, when rates go up, bond prices go down.

Scenario 3: Rates have gone down. Rates going down is the best possible scenario for bonds. Suppose interest rates have fallen to 3%, but your bond is 5%. Since you offer a better interest rate than the market, you can charge a premium for your bond. In our scenario, you could sell your bond for $1,056.97, or 5.697% higher than the face value of the bond. 

When interest rates are falling, bonds are a no-brainer. After interest rates climbed to 20% in the 1980s, there was no place for rates to go but down. However, while the rates rose to 20%, bonds were the worst place to have money. High inflationary periods like the 1970s and early 1980s are excruciating. Still, they also can be a guide to how to arrange a portfolio. If inflation is high, interest rates will rise to slow down the economy. It is like a tornado warning for a bond portfolio. Get out of bonds, wait for the interest rates to drop, and then pile back into bonds.

Most savvy investors will sell their bonds at the rumor of higher interest rates. Then, they move or rebalance the money into other safety assets like precious metals. Investors will also move into real estate as a safe asset in other market conditions. However, raising interest rates will affect housing prices similarly to how they affect bonds. When interest rates go up, housing prices tend to go down.

In certain market conditions, the safest asset is precious metals. Most people like to put a small percentage between 5-20% of their portfolio in precious metals as a safety net against the dangers of the stock and bond markets. However, rising interest rates make mitigating risks in stocks, bonds, and real estate especially challenging. Risk-averse investors tend to put more than 20% of their portfolios into precious metals when interest rates are rising, but there are many factors going into every investment decision. 

The experts at the U.S. Gold Bureau will educate you about precious metals for free.

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