Which best describes the difference between stocks and bonds?
This was a question I received earlier today during a portfolio consultation for a new client. This investor had been told by their former financial advisor to diversify their holdings through a blend of stocks and bonds.
Awesome, I am sure their former FA got a nice commission on those purchases but left this client without knowing anything about the differences between stocks and bonds.
Again, the goal for Wall Street is to gather assets and charge fees so it makes sense. Confuse the client. Get a commission on their money. Rinse. And repeat.
So…what’s the difference? And do blends of stocks and bonds offer the best returns?
Great. And to be honest I didn’t even watch this video. Here is what really is going on:
Which Best Describes the Difference Between Stocks and Bonds? Ownership!
Shares of stock are shares of companies. Let’s take Snap as an example.
Snap is a private company who wishes to grow but they are unable to do so with the cash the company currently generates.
An option for these companies is to turn to the public markets where they can sell a portion of these shares to the public in exchange for money (what you pay). This gives the company selling the shares to the public cash in exchange for ownership (very small) in their company.
This premise is how the financial markets started. We live in times when people are just buying and selling stocks to make money (full disclosure we 100% are and rarely even know what company’s we trade do). However, the stock market was founded on the premise that individuals could have ownership in a company in exchange for equity. In a way, they would attain equity through funding a public company.
Bonds, on the other hand, are debt. Rather than issuing stock (ownership/equity) in exchange for cash, companies/governments/anyone will borrow money and pay interest on that loan to investors. Each bond has a par value (what the bond is worth, say $100,000) and pays a coupon (interest) to the investor. For example, this $100,000 bond may pay a 5% coupon. Those coupons are paid semi-annually so the investor will receive $2500 twice a year until the bond matures. If the issuer does not default, the investor receives the initial principal back when the bond matures.
Which is Right for You?
One of the things Wall Street like to talk about is the negative correlation between stocks and bonds. That is bullshit.
We compared the price movements of $SPY (S&P 500 Index ETF) and $TLT (20-30 year bond ETF) over the last year. If they both went up 1% for the day, we marked that day at 100 correlation. If $SPY went up 1% and $TLT went down 1% on the same day, we would mark that at -100 correlation. So how did they do?
A 1.72 is as close to ABSOLUTELY FREAKING ZERO correlation as you can get. What this means is that stocks and bonds currently move independently and are completely uncorrelated. Myth debunked. Boom.
What about bonds? Can we make money with bonds? Well, the single bonds that are the most accepted in the industry as no-risk bonds are US Government Bonds. Right now on a 30 Year Bond, an investor can get 3% a year on their principal.
But they are far from no risk. Take a look at how much debt the United States has acquired over the years. God forbid the interest on their debt ever goes up. Guess who’s going to take a hit? Yup, you guessed it…US Bond holders!
Nice job everyone way to get to that 20 trillion mark. There is real default risk here.
What to do?
Well for starters…don’t buy bonds. If you would like to buy bonds, keep your money in a high yield savings account. The reason I say this is because if you actually just want to make 3% on your money, you are just sitting on the sidelines.
Buy stocks when they are down. Sell them when they are high. It’s simple people.