Many investors are concerned right now about the ongoing fiscal jockeying between our polarized national political leadership. This concern is often boiled down to how the fiscal negotiations will impact common investments like a retirement portfolio. This is a complex answer and a starting point for this column will be an overview of just what stocks and bonds really are.
A common stock share represents ownership in a company's assets and their future growth. If the company does well and prospers, the stock share should rise. A bond represents a debt owed by a company to you and is secured usually by assets and future income. One (stock) is ownership and the other (bond) is an obligation to repay your principal with interest.
Common stock is frequently mentioned in the news - the Dow Jones is a common example. A stock really does not represent a guarantee because it is purchased with the expectation that the share should rise in value and in many cases will earn a share of company profits quarterly called dividends. Dividends are paid after all expenses have been met and other cash needs have been met. Common stock has no maturity so it can be held perpetually.
A bond has a set time frame for maturity and a set schedule when interest is paid to the bondholder, most commonly twice per year. At the end of the set term, the final interest payment is made and all principal should be returned to the bondholder. Bonds, like stocks, can be sold in what is called the secondary market. And like common stock, various factors should be considered before purchasing bonds, such as the financial strength of the company, inflation that could impact true value, and various tax consequences. Traditional theory suggests that stocks should outpace rising inflation and that bonds will not, especially if a corresponding rise in interest rates occurs.
Stock prices vary on a daily basis based on a number of economic factors and can have a high degree of volatility. Bond pricing and fluctuation can often be much less volatile and can function with a fairly high degree of pure mathematics in determining true value. Bonds will have some fluctuation in prices but it is generally less than stocks have in more normal economic times. It is important to recognize that our current economic environment is not really normal since interest rates are the lowest ever recorded and can only rise over time. This could cause a very exaggerated rise in bond price volatility that investors must be aware of and must be prepared to avoid if at all possible.
But here's the true dilemma: Many investors are willing to risk some volatility and lower dividends with the goal of a higher total return. Perhaps the stock rises in value and increases their dividend either to keep pace with or possibly to outpace inflation. A bond cannot generally do that so will inflation create a major decline in purchasing power in the 3 percent bond discussed above? Again, I can't stress strongly enough that we are in an incredibly dangerous time to be buying longer term bonds at historically low prices. If we see any degree of inflation, those investors holding low yielding bonds will be in a dire situation. Those investors holding stocks might be rewarded with a stronger appreciation. But here is the key to investing: Having a properly diversified portfolio that is actively managed to take advantage of these sorts of scenarios.
Clearly there is much more work involved than just buying common stocks and bonds; however, we are fortunate that over the past 30 years this has evolved so that we have thousands of mutual funds from which to select. And many mutual funds tend to be very good at investing in both stocks and bonds where the fund managers sort through the economic noise and chaos for us. We have a portion of our client portfolios invested exactly this way. But no matter which investments you decide to hold in your portfolio, an understanding of how a common stock and bond operate is very important. And if you have something you'd like me to write about in a future column, let me know.
Ryan Fox is director of the Financial Consulate, 131 Carlisle St., Gettysburg; call 717-334-1861 or visit email@example.com or www.ryanfox.info.