We hear a lot about mutual funds, unit investment trust, exchange traded funds, hedge funds, alternative investments, and put and call options. These can be further broken down into balanced funds, long-short funds, and alpha and beta funds. The terminology can get deeper and deeper, and it becomes more confusing as more layers of description are added.
Almost all of the above employ the two most basic parts of investing – stocks and bonds. That’s it.
Sometimes we need a refresher in these two primary components of investing.
Let’s start with bonds, which are debt obligations issued by federal, state and local governments as well as corporations. They are not ownership interest, and they typically have a stated maturity ranging from several months to 50 or more years.
The entity issuing bonds agrees to pay the bondholder a set amount of money for a determined amount of time. The longer the maturity, the higher the interest rate offer compared to shorter maturities.
Longer maturities pay higher interest rates primarily because of two things: interest rate risk and default risk.
Longer-dated bonds behave inversely to current interest rates. If interest rates rise, the value of the longer-dated bond drops to reflect this higher interest rate. Shorter maturities react less to changes in interest rates. If you look at bond maturities as one end of a teeter-totter and interest rates as the other, it may help to visualize the inverse relationship between changes in interest rates compared to an already-issued bond. As the interest rate goes up at one end, the value of the bonds decreases at the other. If interest rates go down, the value of the existing bond will increase.
The other risk is default risk. The longer the maturity date, the higher the chances of something affecting the ability of the bond issuer to pay bondholders.
There are companies that rate bonds, with Moody’s, Standard & Poor’s and Fitch three of the more familiar services. Many bonds are rated “investment grade,” which typically is a BBB rating or better. Anything below BBB is considered junk or high yield. There are some, but not many, AAA corporate bonds issued. Only direct obligations of the United States, bills, notes and bonds are guaranteed by the full faith and credit of our country. Some such as municipal bonds may pay interest that is free from state and federal income tax.
In the case of a company default, the bondholders are paid first, ahead of common stockholders – assuming there is anything remaining to pay out. They are lenders to the company, not owners.
Stockholders are owners of the company. They take more risk than bondholders. As the company performs, so do the stockholders. Some stocks pay dividends, and there are several types of stock.
Many investors are most familiar with common stock, but there is also preferred stock, which may pay a dividend higher than what the common stock dividend pays. There also are some preferred stocks that can be converted into the common stock of the underlying company.
Common stocks can be sliced many ways. There are large cap, medium cap and small cap stocks. There are value stocks and growth stock, as well as a blend of value and grow stock. Growth stocks tend to pay little or no dividends, as they often reinvest their profits back into their company.
Stocks can further be broken down into sectors, including technology, healthcare, transportation and utilities. Then there are common stocks of foreign countries, which come with their own potential for return as well as risk. In the case of default, stockholders are paid – if anything is available – only after the bondholders. Common stockholders are paid after the preferred stockholder.
Diversification is achieved by using a combination of stocks and bonds, and it may help to reduce the systemic risk associated with the stock market. Having bonds in a diversified portfolio can help provide a brake for a falling portfolio of stocks. Conversely, bonds also provide a brake for an increasing portfolio of stocks.
Diversification is synonymous with asset allocation, which is how one diversifies between major asset classes such as stocks and bonds. It also encompasses different sectors and types of stocks and bonds.
Many studies have shown that asset allocation is the major driver of portfolio returns. It is much more important that trying to time the market.
Remember, revisiting the basics of stocks and bonds from time to time hopefully will make for better investing.