All About Stocks and Bonds (repost)

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This is a repost from an April 17, 2004 (almost exactly 2 years ago!) article I wrote about stocks and bonds. Today: stocks and bonds. Tomorrow, mutual funds and index funds. Then we’ll continue on with the financial makeover. And yes, I know my writing style has changed since 2004.

Stocks
When you own a company’s stock, you own part of that company. If it does well, your stock will do well. You can buy and sell whenever you want through your broker or self-serve sites like ETrade or Datek.

Advantages: You can beat the market if your stock is good; if your stock is excellent, you can really beat the market. You can pick the stock in an industry you understand. Also, your money is liquid, meaning you can access it at any time by selling your stock.

Disadvantages: Unfortunately, if a company does poorly, so does your stock. Because a stock isn’t diversified, that can mean disaster for you (although you can easily reduce your risk by picking bigger, solid companies). Also, most people are not good at picking excellent stocks. In fact, they think they are but they really aren’t (more about investor psychology).

Inevitably, when I’m teaching the basics of stocks, someone will pipe up and say, “So what stock should I buy?” Let’s go through it.

The simplest way to narrow the universe of stocks is to think of companies you like and use. What are 15 companies you use and return to time after time? Think of everything, including food, clothing, services, technology, entertainment, transportation, etc. There, you just went from 5,000 stocks to 15.

A good company isn’t necessarily a good stock! Let’s think of clothing for a second. What are your favorite places to shop? Abercrombie? Guess? Gap? Ok, take Gap. Let’s do a very simple analysis of Gap as a company. It has good clothes that are consistent and stable: Khakis, white shirts, polos, jeans, things that don’t go out of style. They appeal to men and women. They have a lot of locations and some great advertising. Hell, I shop there. Unfortunately, good products don’t always make a good stock: Here’s Yahoo’s 5-year stock performance. In this 5-year period, they dropped from a high of around 52 to a low around 8. “But Ramit,” you might say, “the entire economy was in a recession.” Yeah, but Gap also severely underperformed the market during this time.

The point is that you need a deeper analysis than “I think their khakis are pretty.” For that, you need to know:

Trends. Are sales increasing from this time last year? 2 years ago? 5 years ago?
Products. Is the future bright in terms of upcoming product development?
Revenues, profits, growth, earnings per share. The real financial nuts and bolts of a stock, these are intimidating at first. Luckily, many sites will guide you though it.
Insider trading. Are senior executives at the company buying more stocks (indicating they have confidence in the company) or selling?
Management. Is management good? What is the turnover? What is their philosophy and ability to execute?

You can get all of this information online for free. Here are some great sites to start you out.

The MSN Research Wizard will help you analyze a stock step-by-step.

Yahoo Finance lets you view the standard details about any stock.

The Motley Fool is great for first-time investors.

Once you start looking at charts, earnings, balance sheets, etc, you’ll start to get a good sense of what’s going on. It just takes practice.


Bonds
Bonds are IOUs, like CDs (certificates of deposit). If you buy a 1-year bond, the bank says “Hey, if you lend me $100, we’ll give you $102 back in a year.” The approximate current rate of return for a 2-year bond is 2.89%.

Advantages: You know exactly how much you’ll get when you invest in a bond. You can choose the amount of time you want a bond for (1 year, 2 years, 5 years, etc). Longer time periods yield you higher return rates. Also, bonds are extremely stable, especially government bonds. The only way you’d lose money on a goverment bond is if the government defaulted on its loans–and it doesn’t do that, it just prints more money.

Disadvantages: Unfortunately, bonds have significant disadvantages. Because they’re so stable (lower risk), the reward on an excellent bond is dramatically less than an excellent stock. Investing in a bond also renders your money illiquid, meaning it’s locked away and inaccessible for a period of time. That’s usually bad.

With these qualities, what kind of person would invest in bonds? Let’s see…extremely stable, essentially guaranteed rate of return, but relatively small returns…who would it be?

If you said “me” and you are in your twenties, I want to punch you.

Actually, it’s old people and rich people who find bonds most attractive. Old people need to know exactly how much money they’re getting next month for their medication or whatever old people do; they can’t stand the volatility of the stock market because they generally don’t have much other income to support themselves. Rich people, on the other hand, have naturally become conservative with so much money. Put it this way: When you have $10,000, you want to invest aggressively to grow. When you have $10 million, you want to conserve. So a guaranteed bond at 2% or 3% is attractive–and 3% of $10 million is $300,000 anyway.

Now you see why bonds are exactly the wrong investment for most young people. Also, with a longer investment outlook, you can invest more aggressively to get much higher returns than bonds.

Now what?

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9 Comments

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  1. >If it does well, your stock will >do well.

    Shouldn’t it read something more like:

    “If it does well, your stock may or may not do well, depending on market conditions, the health of that firm’s industry, and investor perception of how the company is performing”

  2. Is there a ratio that tells you a stock’s price in relation to the company’s assets and profits?

  3. Joe W. … PE = P/E = Price over Earnings.

  4. Well to be more specific P/E = Price divided by earnings. It is a measurement of stockholder enthusiasm. How much the market is willing pay for the earnings. It goes without saying that growth tech stocks like Google carry astronomical P/Es because they have lots of growth potential and the price is based on future earnings, not past or present earnings.

    Price to Book Value (P/B) is a ratio of the price of the stock to the bottom line: assets and free cash.

  5. I know this is probably a “newbie” question, but I read an article recently that talked about the “Magic Formula” at
    http://www.MagicFormulaInvesting.com
    and I’m curious as to your thoughts. from what I understand, it puts the P/E ratio on its head in a sense, going on return on capital… it seems like it uses the P/E ratio in regard to its market capitalization. I guess thats how its “magic” needless to say, I’m just curious what some of your thoughts would be on it.

  6. The only way you’d lose money on a goverment bond is if the government defaulted on its loans–and it doesn’t do that, it just prints more money.

    I imagine you are talking about American bonds, but for the record Russia defaulted on its bonds in 1998.

  7. You don’t indicate exactly what kind of bond was giving ~ 2.89% back in April of 2004 so it is difficult to compare. If you had purchased an I Bond in April of 2004 it would have started at 6.83%. Since then it would have changed to 6.73%, 6.93% and 6.73%. Well above the 2.89% rate you noted.

  8. Thanks Kieno, that’s what I was looking for. Any ideas why Amazon and Yahoo!’s P/B are so different? Amazon’s seems astronomical (60.56) compared to Yahoo’s (5.84).