Each shareholder has a partial ownership in your car wash corporation. They took what is called an equity position and will participate in the future gains or losses of the corporation as long as they own shares. If your company has real earnings and a good growth pattern, it will ideally pay the stockholders a dividend, or a share of the profits, over the long term.
In the short term, the price of any stock can be affected by behavior of the market. For instance, an entire sector of the market could be down and, regardless of how healthy that company is, the price of the stock could go down. For example, when the entire tech sector fell out of favor, the price of IBM stock dropped from about $133 a share in August 2000 to about $76 in May 2002. A price of $76 was arguably too low based on an analysis of the solid business IBM was doing. This is a case where movement in an entire sector as well as the entire market affected the price of the stock. In the longer term—a two-to-five-year time span—the price of stock will be determined more by the earnings of the company.
When I think about the lack of predictability of stocks, I’m reminded of some famous advice that the cowboy-turned-philosopher Will Rogers once gave. “Don’t gamble, take all your savings and buy some good stock,” he advised. “Hold it till it goes up, then sell it. If it don’t go up . . . don’t buy it.”1 Will Rogers reminds me that there’s no such thing as a sure bet or a guaranteed rise in stock prices—and helps me keep my sense of humor.
Now let’s examine bonds. A separate and distinct asset class from stocks, bonds are considered debt instruments. They are essentially IOUs to the people investing in them. Remember that car wash corporation that issued stock? Now let’s assume that the car wash also wants to borrow some money.
Instead of going to the bank, it decides to borrow the money from individuals. If it wanted to borrow $100,000 from 10 individuals, it would create 10 bonds worth $10,000 each. In order to attract people who will loan it the money, the company generally has to offer to pay a higher rate of interest than is otherwise available. Since guaranteed bonds issued by the U.S. government may pay about 5.5 percent, your car wash will need to pay bondholders at least, say, 8 percent to encourage people to buy its bonds despite the increased risk a company poses over that of the U.S. government.
People who are going to loan the corporation $10,000 don’t want to wait indefinitely to get their money back. So the car wash decides to have the bonds “mature” in 10 years. That is when the investors will get their money back. The car wash bond investor will essentially be making a loan of $10,000 by buying a 10-year $10,000 bond. Each year the bondholder will be paid interest of 8 percent—$800 a year. The bond is guaranteed by the corporation. As long as the corporation is financially sound, the investors have a reasonable assurance they will get their principal back.
It sounds simple—a guaranteed loan for 10 years at a nice rate of interest. That appears to make it a safer investment than the stock in the same company. But while bonds are considered to be lower on the riskscale than stocks, they are not risk free.
Why? Let’s say in the third year, Uncle John—one of the $10,000 bondholders—gets sick and needs the money. At that point, he will be forced to sell it at the market price. There are a number of variables that determine the price Uncle John will get for his bond. One of the key elements is the relationship between a bond’s interest rate and the interest rate of new bonds in the existing market.
It boils down to this: If interest rates rise above the level at which Uncle John bought his bond, Uncle John will probably get less than the $10,000 he paid if he must sell it before it matures. If interest rates fall, Uncle John may be able to sell his bond at a premium, getting more than he paid for it originally. (This is the old playground teeter-totter analogy: When interest rates go up, existing bond values go down, and when interest rates go down, existing bond values go up.)
Why does it work this way? Say interest rates have gone up from 8 percent to 9 percent. The value of Uncle John’s bond needs to compensate a new investor for the higher yield that he or she could reap from a new $10,000 bond pegged to the higher 9 percent interest rate (which would pay $900 annually) rather than Uncle John’s bond’s 8 percent (which pays $800 annually).
If Uncle John decides to sell his bond at the end of the third year, we know there are seven remaining years when Uncle John’s bond will pay $100 less than what an investor would get from a new bond. So Uncle John may get only about $9,300 for the bond. That’s the original bond price ($10,000) less the loss of $100 in additional interest over seven years ($700).
However, Uncle John could luck out. Let’s say interest rates have fallen to 7 percent and a comparable $10,000 bond yields only $700 a year, or $100 less than Uncle John’s bond pays. In that case Uncle John may be able to sell his bond for somewhere in the neighborhood of $10,700. That’s the original bond price ($10,000) plus $700 to account for the additional $100 in interest Uncle John’s bond will offer over seven years.
Of course we have greatly simplified this matter for illustration purposes. Bond prices are affected by a great many other factors, such as inflation and the length of time to maturity. For example, the longer the time before the new investor can get his or her money back (maturity date), the more the bond is discounted. The bond industry uses voluminous tables and high-tech calculators to sort out all the variables that go into pricing. But what’s important to remember is this: There’s no such thing as a free lunch. There’s also no such thing as a risk-free investment, even in bonds.
Read More : Stocks and Bonds: A Primer
