An analogy for the stock and bond investor

While the timing of buying stocks and bonds depends on interest rates, the methodology for making your selection is very different. I often tell students that if investments were like high school students, I’d want my bonds to be B/C students and my stocks to be A students. What does that mean?

Straight A’s – Buying shares

When looking at the risk of owning stocks, we must always remember that common stockholders are the last priority to receive payment for failed securities. If you own stock in a company and it falls on hard times and eventually goes bankrupt, chances are you’ll lose every penny you invest. You see, when a company goes through the liquidation process, the capital left in the business is distributed in a certain order. This command is:

1. Loans

2. Bonds

3. Preferred stock

4. Common actions.

By owning a company that is highly leveraged, the chances of the company experiencing bankruptcy are greatly increased. If this event occurs, most of the remaining capital will be used to return investments to bank loans and bondholders. In most cases, these holders still lose money. As you can see, owning a common stock requires a great deal of trust and confidence in the companies ability to sustain operations in difficult times. Think of it from this perspective. Is it easier for a person to grow their wealth and avoid slow financial growth by avoiding debt? The answer to this question is obvious: yes. Well, owning shares in a company is no different. Avoiding companies that carry a lot of debt often leads to profitable returns.

B/C students – Purchase of bonds

When a person goes to the bank to buy a home, they often get different interest rates than other customers. The reason is directly related to the borrower’s risk. When companies issue bonds, investors experience the same. If the business is not stable and may fall on hard times in the coming years, investors will demand a higher return for their money. So how much return is good return while still taking risk into account? 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 company’s ability to increase its profits and increase market share. With bonds, all we are concerned about is the company’s ability to pay its debts. In the end, I could care less if the company’s product is successful in the long run. I just want to know if the product is successful enough to keep the business going. As a student, I only care if they get a passing grade. If they do, they stay at school to fight for another day.

You see, stock investors are rewarded for exceptional performance. Bond investors are rewarded for having security that is good enough to continue trading. While this mindset may seem brazen, it’s the only way you’ll be able to align your assessment of risk versus reward for two very different types of securities.