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 A students. So what does that mean?
Straight A’s – Stock Purchase
When looking at the risk of owning stock, 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 you find yourself in a tough spot and eventually file for bankruptcy, you will most likely 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 order is:
1. Loans
2. Jumps
3. Preferred Stock
4. Common shares.
By owning a company that is highly leveraged, the chances of the company declaring bankruptcy are greatly increased. If such an event occurs, most of the remaining principal will be used to return investments to bank loans and bondholders. In most cases, these holders continue to lose money. As you can see, ownership of common stock requires tremendous confidence in the companies’ ability to sustain operations during difficult times. Think about it from this perspective. Is it easier for a person to increase his wealth and avoid slow financial growth if he avoids debt? The answer to that question is obvious: yes. Well, owning shares in a company is no different. Avoiding companies that have 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 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 thing with investors. If the business is not stable and may experience hard times in the coming years, investors will demand a higher return on their money. So how much of a return is a good return while still taking risk into account? Well, this is a very important question to answer.
When we were dealing with stocks, future business returns were directly related to the company’s ability to grow its earnings and increase its market share. With bonds, all we care about is the company’s ability to pay its debts. In the end, I couldn’t care less if the company’s product is successful in the long run. I just want to know if the product is successful enough for the business to continue operating. As a student, I only care if they have 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 foolhardy, it’s the only way you’ll be able to align your risk versus reward assessment for two very different types of securities.