Week 1 Lecture

A good portion of the lecture is based on an article that I found on stocks vs. bonds — it might be basic for some of you, but I found it refreshing and clear as to how Mr. Martin portrayed the two concepts — enjoy!   The discussion questions will be at the end of the lecture.  (Please disregard the spelling errors and sentence structure in the article – -this is how it was given in the online forum).
 

A LESSON IN STOCKS AND BONDS
Understanding the basics can make a big difference in your financial future .

By Ray Martin – NBC “Today”;
It is an alarming trend that individual participation in the stock markets has increased exponentially through electronic trading services, which have made it possible for individuals to buy and sell stocks and bonds at will.

Among other things, the survey pointed out these findings: a More than half of Americans don’t know the difference between a stock and a bond. n About as many do not know that stocks have outperformed bonds, treasuries and certificates of deposit over the past 30 years. n About half wrongly think that “diversification” provides a guarantee that their portfolio won’t suffer when the market drops. And individual investors haven’t learned from the recent volatility of the markets. Over the summer many zigged in and out of their holdings, often at exactly the wrong time. They pulled out of stocks after they fell, bought back in after they rose, failed to invest in alternative investments (diversify) and loaded up on the same investments they already owned (such as company stock). So, here are some tips that will help both the beginner and those who could use a refresher crash course on stocks and bonds.

STOCKS
A share of stock is a share of ownership in a corporation. A corporation is owned by its stockholders – often thousands of people and institutions – each holding a fraction of a corporation. As a stockholder, you corporation. own part of every building, office furniture, machinery – whatever that company owns. Your percentage of ownership of a company is the percentage of the shares that you own. Shares of stock in a company entitle you to vote on major policy decisions. Many companies parcel out portions of their annual profits to stockholders in the form of quarterly dividend payments.

To find the value of a company you would simply multiply the number of shares of the company’s stock by the current market price of the stock – a term that is referred to as it’s capitalization. In practical terms, think of stock as similar to your equity in your home. It’s something you own and the value depends on what you could sell it for to a willing market buyer. Like your home’s value, there is no assurance that the stock value will be higher when you sell than it was when what you bought it.

BONDS
A bond is a loan of your money to a company. Like most of us, many companies and even the U.S. Government find it useful to borrow money occasionally. If you’ve ever lent money to friends or family (which is usually not a good idea) and you were paid back both the money lent and some interest then essentially you’ve invested in a bond. As a bond investor, you are a lender of money to a company, not an owner. The company is obligated to pay you the interest during the loan and return the loan at the end. If you need to get your money back before the borrower is obligated to repay, you can sell your bond to other investors.

A simplified way to describe the value of your bond is the sum of the money lent, adjusted (upwards or down) for the difference in the rate of interest on your bond versus the rate on new bonds of similar terms.

That sounds simple enough, but what’s the deal with bond prices and interest rates? The rule is that interest rates and the state of the bond market will have an affect on the price of your bond. Here’s an example:

Suppose you bought a bond for $10,000 that paid you seven percent interest for one year and then returned the loan of $10,000 at the end of the year. You would collect $700 interest and then your loan of $10,000 would be returned (matured) for a total of $10,700. Then suppose that the very next day after you bought the bond, two things happened: interest rates went down to 6 percent and your neighbor wanted to buy your bond. Would you sell it to him for $10,000? Of course not!

Since new bonds are only paying $600, your bond pays an additional $1 00. So it would be fair to sell him your bond for $10,100, to compensate you for the extra income your bond provides versus bonds currently available in the market.

This is why bond prices move up when interest rates go down, which has been the situation lately. Of course, interest rates can and will go up and folks who invest in lower rate bonds will be affected by losses on their bonds, to some extent. A finer point of this concept is that the longer your bond is locked into an interest rate (ten years versus one year) the greater the effect on its price by changes in interest rates. That’s because longer-term bonds have several years of higher or lower income, which must be adjusted into today’s price. You don’t have to do the math to figure out the difference. It’s done for you automatically by the bond market, which establishes fair prices daily based on current interest rates.

HOW DO STOCKS AND BONDS COMPARE?
Stocks and bonds are similar in several ways. First, they can both be bought and sold in what’s called a financial market. Both have risk, meaning that you are not guaranteed or locked into a rate of return that will never change.

Finally, over the past 30 and even 72 years, both have provided returns that outpace inflation.

But stocks and bonds are very different when it comes to important aspects of investing. First, like a loan to your rich uncle Alfred, loans (bonds) to established, well-managed companies and the US Government offer a reasonable assurance that you will get a return of your money as well as a return on your money. Stocks provide no such assurance. Second, bonds provide regular interest payments, typically every six months. Other than dividends, stock returns in the form of price gains can be sporadic and unpredictable. Finally, on average, bond returns are lower over time than returns on stocks. Apparently, their stability and assurance comes with a price.

When it comes to stock and bond returns, it’s important to look at some numbers for a perspective. According to Ibbotson Associates Inc., from 1925 through 1997 the returns of stocks, bonds and inflation were:

Returns 1925-1997
Sm Cap Stocks – 12.7 percent

Lg Cap Stocks – I 1.0 percent

LT Bonds – 5.7 percent

Inflation – 3.1 percent

Many investors stop there and conclude that for the long haul, stocks are the way to go. While that may be true, it can also be terribly misleading. First, these numbers are a history report and not an accurate picture of what the future will be. Second, if you were to look at a chart of these investments over time, the upwards line for stocks, while steeper than bonds, would be much more erratic or jagged. In short, that’s a picture of the risk of ups and downs in stocks. The bonds “picture” is a virtually smooth, upwards line, albeit not as steep as stocks.

Look at the risk factor of stocks vs. bonds over the long term:

1925-1997: ——– Returns ——— Risk

Sm Cap Stocks:      12.7 percent       30.4 percent

Lg Cap Stocks:        11.0 percent      20.3 percent

LT Bonds:               5.7 percent         8.7 percent

Inflation 3.1 percent

DQ

Why not just own one or two great stocks and forget about them for 20 years and retire rich? First, a great stock today will not always be great tomorrow. Business downturns, lawsuits and poor management can have significant impacts on companies. Next, according to a well-regarded study, how you spread your money among stocks and bonds explains over 91 percent of how your investment returns vary. Choosing a mix of different investments can actually reduce the amount returns vary (risk) without reducing the return.DQ1
Comment on the (stock/bond) article from the lecture and state whether you agree with the author’s view of the general public’s knowledge of stocks and bonds. Do this in conjunction with your Week 1 readings.

DQ2

Comment on the (stock/bond) article from the lecture and state whether you agree with the author’s view of the general public’s knowledge of stocks and bonds. Do this in conjunction with your Week 1 readings.