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Home > Investing > How Stock/Bond Investments Make Money

How Stock/Bond Investments Make Money

October 28th, 2011 Leave a comment Go to comments

In a previous post, I discussed why cash is not a good investment (due to inflation and and its inconsistency in its ability to generate reliable income). If you use your cash instead to invest in stocks or bonds what is it that you are getting and how does it make money?

First, Your Principal is at Risk

Holding cash in insured savings, checking accounts or in money market funds will give you virtual certainty of keeping your principal safe. So, even if interest rates go up or down at the very least you will still have your principal. When you make the transition to other investments, your principal is no longer safe. You can lose money or make money due to the change in value of the asset.

In exchange for risking your principal, you can get the potential benefits of consistent income or a higher return, and in some cases both.

How Bonds Make Money

Bonds are loans made to companies, governments, and other institutions that offer the ability to earn consistent returns through interest payments. Unlike cash investments, the interest that bonds offer is more consistent, though not all are at fixed rates but most bonds do pay interest at fixed rates. So, if you need a consistent earnings stream over a known period of time bonds are a good way to go.

If you buy quality bonds and hold them to maturity, you will have earned interest along the way as well as get the principal back at the end of the term. Bonds are thought as being ‘safer’ investments compared to stocks, but you can lose money on bonds if you sell them before they mature. To understand why consider this example:

  1. Today, buy a 10 year U.S. Treasury bond, earning interest of 3% per year.
  2. The economy recovers, investors buy more corporate bonds and have less interest in U.S. Treasury bonds.
  3. U.S Treasury bonds are offered at auction at lower prices, so new bonds now pay 5% per year.

If you want to sell your U.S. Treasury bond today, you are competing with new bonds that offer a higher interest rates. So, to find a buyer you will have to sell at a loss of principal to compensate for the difference in the lower yield of your bonds. This is how you can lose money with even the highest quality bonds. Of course, if you never sell the bond, then you don’t lose any money.

In the example above, there is very low risk of default with U.S Treasury bonds. With other types of bonds, such as those issued by private companies, municipal bonds issued by governments there is some level of risk of default. This risk would manifest itself in a price change for the bond. Also, these bonds have the same interest rate risk as shown in the example above.

How Stocks Differ from Bonds

When you buy a bond from a publicly traded company, you are only asking for return of principal plus interest. When you buy a stock issued by a company, you are taking a direct stake in the success or failure of the firm.

This is riskier than buying the bonds from the company. A poorly run company can make a little money but still pay its bond holders leaving its shareholders with low valued paper. Also, debt issued by companies typically is higher up on the totem pole from a company obligation standpoint. Bondholders will get paid before shareholders when push comes to shove.

This has been demonstrated in the wreckage and fallout of many financial firms that trade on the public markets. The common shareholder has taken it on the chin both in stock price and dividend income. However, the bondholders and preferred stocks holders (special issue stock that really has characteristics of bonds) have generally fared better, they still are getting paid fully. But, like the common shareholder the value of the bonds has gone down.

How Stocks Make Money

The equivalent basis to compare stocks to bonds is with Return on Equity (ROE). The ROE is the income a company makes each year as a return for all the equity invested. Equity means all the money that shareholders invested over time  in the company. From the company’s point of view equity is cheap money, they don’t have to pay any interest on it. In exchange for the cheap money, the shareholder can claim ownership to all the companies assets and future earnings. Pretty cool?

Here is the ROE for a few very high quality companies:

  • Johnson & Johnson (JNJ):  30%
  • Microsoft (MSFT): 50%
  • Exxon Mobil (XOM): 38%

Don’t run out to buy these stocks just yet! You won’t earn 50% per year buying Microsoft because that’s the return for original invested equity, not what it is worth now. Because Microsoft has been quite successful at increasing its income over the years, investors have bid up its stock price and by definition the price of its equity. As an investor this is good.

So, What Will You Earn on Stocks?

In order to determine what your return on investment will be for a company, you need to consider the current price of its equity, or its stock price. If you use current values for the (3) companies above then investors who buy these stocks today would get the following annual return on investment. This is determined by dividing the yearly net income for the company by its stock price:

  • Johnson & Johnson (JNJ):  9%
  • Microsoft (MSFT): 11%
  • Exxon Mobil (XOM): 10%

Compared to bonds yields of current 10 year U.S. Treasury bonds (3%) , these returns look great. But, there is more risk here (maybe not for these 3 companies as much as others), whereas the bond is very secure.