Good morning & happy Monday!
“Risk comes from not knowing what you are doing.”
– Warren Buffett
I am fully aware that this investing world can be overwhelming, difficult to understand, and downright confusing. This morning I would like to go back to the basics of investing: what is a stock and what is a bond.
I know this may be elementary to some, but I think it warrants visiting because I believe it is important to know what you own, and thus what you are doing as an investor.
Bonds = debt
Stocks = ownership
I oftentimes find illustrations best make these principles come alive, so I will attempt to do that here.
Let’s say I decide I am going to open a second Intentional Wealth location in another town (completely hypothetical, not at all planning on doing this). Let’s say to purchase a new building, staff it, pay the electric bill and all the other expenses associated with this purchase will cost $500,000.
Now if I were to do this, I would expect that over time opening a second location would be a profitable endeavor, otherwise I wouldn’t do it.
I don’t want to use my own funds so instead I go to you and say “Hey, I’m opening this second location, how about you lend me $500,000 and I will pay you back 8% on a 10-year term?” (Just so I am crystal clear here, this is not happening, I’m just using it as an example … I never borrow money from clients, one of the biggest no-no’s in my line of work.)
In this example, if you decide this is a good deal and you lend me the $500,000, I in turn will pay you $40,000 every year (8% of $500,000) for the next 10 years. At the end of 10-years I promise to return the initial $500,000 back to you.
In this example you purchased a bond, you are purchasing the debt of a business or entity. As long as I don’t default, this is a fairly safe investment because you know what you are going to get (8%) and for how long (10 years). There are other risks, but I’ll address that another time (likely next week).
Now, what if you look at my loan proposal and say “I love the idea of you opening a second location, that will no-doubt dramatically increase your business profits, but I’m not going to lend you the money. Instead, I will invest the $500,000 into your business but I want a 25% ownership stake in Intentional Wealth.”
If agree to this then you become a partial owner of my business. You have purchased stock. What type of return do you expect? This is where there are no guarantees at all, but you believe that it will be far more profitable to you to be an owner of Intentional Wealth then a lender to Intentional Wealth.
Did I mention this is a 100% made up example? Just want to make sure that is clear. 😊
This is the concept, and it works on much larger scales in the public market.
Let’s say that Tesla decided they want to build a huge new warehouse in Polk County, Florida. Let’s say this new state-of-the-art facility will cost $100 million (I have no idea how much it costs to build such a warehouse, but let’s just roll with it 😉). Now, I can’t imagine that Tesla is sitting on $100 million cash looking for something to do with those funds, they are a huge business and would be using their cash in other ways to generate profits. So, how would they pay for such a project?
They would issue bonds. Bonds become the way that project would be financed.
So, Tesla in this example would go to the public and basically say “We are building a new warehouse and issuing $100 million in bonds. With those funds we are going to build this new facility and we expect to generate $X profit from this new endeavor, these additional revenues will be used to pay back the bondholders. The terms of this deal are 20 years at 6%.”
Now, if you think to yourself “Hey, that’s a good deal. I can lend Tesla my money and get 6% paid out to me every year for the next 20 years, and then after 20 years I get my initial investment back” you might decide to purchase say $100,000 of this bond offering.
This means for the next 20 years you will get an annual check from Tesla for $6,000 (6% of $100,000) and then at the end of the 20-year period you will receive your initial $100,000 back.
I’m oversimplifying things here, but big picture that is how this works.
That’s bonds … you are lending your money to a business or an entity with the expectation of receiving interest and a return of your initial investment at a future date.
What if you said to yourself “I think I can make more than 6% over the next 20 years if I was an owner of Tesla.” Then you would purchase Tesla stock and would become a partial owner of that company.
No guarantees on what that return would be as a stock owner, but the owners of companies run their entire businesses to maximize profits. So, one must believe over time (and business cycles) that the returns owners would get would be greater than lenders.
Owners are trading safety and predictability for greater opportunity for returns. Is that a good tradeoff? Depends on the person, goals, risk tolerance, time frame, etc. That is where we usually have a combination of stocks and bonds in our portfolios … stocks are designed for growth and bonds are designed to provide an element of safety.
The risks are obvious with stocks but there are risks with bonds as well, heck there are risks with any type of investment.
My plan is to use next week to dive in a little deeper into bonds (since they have been so challenging these last 2 years or so) and then in following weeks I’ll discuss a helicopter view of how stock prices are determined. Stay tuned … I can tell you are excited 😉
Make it an amazing week ahead! Thanks for allowing us to serve you!