Basic Investing – Stocks and Bonds

A discussion of investment types could seemingly continue indefinitely.  There are endless types of investments, all of which carrying their own structure, risk profile, minimum requirements, term….and so on.  Trying to figure out what they all are, whether they’re suitable for your risk tolerance, and the precisely optimal combination is itself a full-time job.  And I’m guessing that if you’re reading this while pursuing early retirement, you already have a full-time job that saps most of your time.  Perhaps the goal of your early retirement is to become a full-time investor.  Good luck.

If my guess is correct, you don’t have the time of day to read due diligence reports to determine if a particular REIT or private placement is where you want to place a large chunk of your holdings.  And, if you’re working for wages (as we all are!!), you probably don’t have enough cash to tie yourself up in something like that and still be diversified.  Maybe someday you’ll have enough cash to drop a million in a REIT and not spend your days driving by the properties to make sure the grass is mowed.  (For anyone who doesn’t know, a REIT is a Real Estate Investment Trust – basically a bunch of properties held by a trust of which you purchase fractional ownership and reap the fractional gains and losses).  As a side note, I will talk about these other, more unique investment concepts in separate posts.

When discussing investing in pursuit of FIRE, what I’m primarily talking about are stocks (equities) and bonds.  These are generally the most liquid, readily available types of investments, and, properly chosen and diversified, skew toward the least risky of speculative financial ventures.  Of course, as I frequently repeat, not no risk – you can certainly wipe yourself out, but history has shown that by taking a long-term view with enough diversification, you’re unlikely to land yourself in bankruptcy court.  Given that a sizeable proportion of the FIRE investment strategy is dedicated to passive investment in stocks and bonds, this post will provide a high-level explanation of those assets.

Stocks (Equities)

Stocks, on their most fundamental level, are a fractional ownership in a company, and there are typically two ways that stockholders earn money from holding them.  First is the increase in the market value of shares – by which I mean that if you buy one share at $50 and you sell it for $100, you’ve earned yourself $50 based on the increase in market value.  The mechanics of how and why stock prices in secondary markets move is so far beyond the scope of this post that all I’ll do is offer you a link to look it up if you’re more interested: https://www.google.com/.  If you start a search with even remotely the right words, I can almost guarantee that an autofill will complete the remainder for you.

The second way stocks pay off is through dividends.  A dividend is essentially a share of corporate earnings paid to the holders of stocks on a particular date (usually the “record date”).  Different companies pay dividends at different rates, and some simple research on the company in which you’re interested in purchasing shares will clue you in as to how often it happens and historical dividend amounts – typically given as an amount per share.  

An important note about dividends that I’ll make here but repeat later is the concept of dividend reinvestment.  Most brokerage accounts have an option to enable this feature automatically but it’s definitely something you’ll want to look into.  In fact, most calculations of long-term stock market returns assume dividend reinvestment.  Simply put, this is when you take the cash payout from each dividend and use it to purchase additional shares of the stock that just paid you the dividend.  You can of course use it to buy other stocks too, which requires manually monitoring for dividends and making purchases.  Now that brokerage firms allow you to purchase fractional interests in shares, setting it up automatically ensures that every penny paid to you as a dividend will be re-invested, and over the long-term can lead to significant additional accumulation that you may not even realize you were getting.

There’s quite a bit more to stocks than I’ve mentioned here.  There are different classes of shares, preferred shares, etc., the differences between which you may never know about unless you study the shares you’re buying.  Generally the difference comes down to voting rights, with different share classes having different structures for voting on company decisions, such as the makeup of the board of directors.  There may also be different rights to dividends, as well as what happens if the company becomes insolvent.  Do your research to know what you’re buying.

Bonds

The other basic investment asset that many long-term investors hold is a bond.  A business (or the government) issues a bond to raise funds, and, in exchange for those funds, the bond issuer will pay you to borrow that money.  There are two primary ways that bonds pay out: interest payments and original issue discount.

You’re probably familiar with the concept of interest – any time you’ve ever borrowed money, you pay the lender interest.  A bond is like that, except that now you’re the lender and the borrower (the bond issuer) pays you interest over the life of the bond.  The term you need to know is the “coupon payment,” which is, effectively, the annual interest rate stated on a bond.  (Now that bonds are mostly held electronically, the term coupon payment is somewhat outdated, but so be it).  Some bonds pay interest more than once per year – typically twice – all of which should add up to the coupon payment on an annual basis.  

The other way that bonds pay is through original issue discount, which means that you pay less than the face value of the bond and then make money when you redeem the bond at its face value when the bond comes due.  This concept may not be unfamiliar.  For example, you may have reluctantly received a US savings bond when you were little.  Said your grandfather (or other elder relative): “here you go, here’s 50 bucks, but oh, by the way, that’s in seven years, so don’t lose this!”  Little did you know at the time that the reason your grandfather gave you a bond was because you thought you were getting 50 dollars, but it only cost him 22 at the time.  What he didn’t think of was that if he’d given you 22 dollars in 1991 and you used it to buy shares of some now well-known technology companies, you’d currently have…….best not to think about it.   

A corporate or government bond with an original issue discount works the same way as your grandfather’s poorly-returning savings bond.  You pay $80 for a bond with a face value of $100 and a maturity date in 5 years, which means that in 5 years, you turn in the bond for your $100.  That 25% increase in value is your return on investment based on the original issue discount.  (25% because it’s a $20 return on an $80 investment, which is 20/80 = .25). 

Some bonds pay both interest while you hold the bond in addition to coming with an original issue discount.  The bigger the difference between the purchase price and the face value, typically the lower the interest payments, and vice-versa, but every bond issuance is different.  To calculate your return on a bond, you have to consider both the interest payments and the return from the original issue discount.

Thus, interest payments and original issue discount are the two most common ways that bondholders earn returns.  But because it’s now the future, you should know that bonds also trade on the open market, meaning that people hold bonds effectively in the same way they hold equities.  Bondholders may sell bonds for a higher price than they paid if the value increases, generating a gain from trading rather than collecting interest or holding the bond until maturity.  How and why bonds fluctuate in price is again beyond the scope of this post, but let’s say that it’s loosely correlated to the future prospects of the bond’s issuer.

You may have also heard of “junk bonds.” These are bonds that, to put it gently, have less of a chance of being paid back.  Most major bonds are rated by ratings agencies (Moody’s, Standard & Poors, Fitch).  Each agency has its own ratings system, but you may see something like AAA, and AA-, etc.  The higher the rating, the more likely the company is to pay back your bond.  The lower the rating, the less likely, and those with lower ratings may fall into the “junk” category.  What attracts investors to these is that junk bonds tend to have higher interest payments and lower purchase prices relative to face value (greater original issue discount) to compensate investors for the risk they assume that they won’t be paid back.  Another option to diversify your portfolio is to hold bonds of different ratings: lower rated bonds for their potential returns, together with higher rated, lower-returning bonds to reduce risk.

Mixing Stocks and Bonds

So what’s the difference between stocks and bonds and why might you hold one over the other or hold a diverse portfolio with some stocks and some bonds?  Generally speaking, stocks fetch higher returns than bonds.  And the reason for this is that stocks are riskier than bonds – that is, you’re more likely to lose money with stocks than bonds.  A stockholder is considered an owner of the company, while a bondholder is considered a creditor of the company.  If the company files for bankruptcy, creditors (bondholders) tend to be entitled to the remaining assets before equity owners (stockholders).  Thus, all things considered, the risk of holding a bond is lower than a share of stock because you’re less likely to see your investment value drop to 0 if the company goes under.  

Aside from the bankruptcy aspect, a bond’s relatively lower risk and volatility are due to the fact that a bond is essentially a guaranteed obligation; regardless of how the issuer performs, it pays you the stated interest or original issue discount (unless it goes belly-up).  A stock, however, is not guaranteed – although correlated to a company’s performance and outlook, a stock can move every which way.  The company in which you own a share of stock might be doing phenomenally, but if a recession hits, the overall market may drag down its share price.  Conversely, if the market is rising, so too may the stock price.  Meanwhile, your bonds will be paying you the stated interest or original issue discount, regardless of which way the market moves.  So overall, bonds tend to be less risky due to their guaranteed nature and the fact that they’re less susceptible to market fluctuations. 

Knowing what impacts stocks and bonds, what is the best way to mitigate long-term investing risk? The answer is almost too simplistic: time and an appropriate balance of risk depending on when you need access to the money from your investments.  This is a critical consideration for pursuing FIRE and planning for early retirement.   

When younger, or when retirement is further out on the horizon – times when you’re less likely to need immediate access to your money – it’s more likely that you’ll hold a higher proportion of your assets as stocks.  This way, as you’re saving and investing, you can (hopefully) reap the growth in market value to reach sufficient net worth to wean your dependency from wage-based employment.  As you get older and closer to retirement, you’ll likely move into some less risky assets like bonds to reduce the risk of your net worth sinking at the time when you actually need it.  This is the typical approach to investing for and while in retirement, though as I discuss in another post, may vary for a FIRE investor.

Finally, it’s important to mention a favorite topic of mine: taxes.  See this separate post for a more detailed overview of the taxes you might incur from your investing: Investing – Common Tax Issues.  Briefly, you’ll incur a capital gains tax on a share of stock when you sell it at a higher price than you bought it, and the rate of tax depends on how long you’ve held the share you sold: short-term (one year or less) or long-term (over one year).  You’ll also be subject to taxes when you receive a dividend, which also varies based on how long you’ve held the stock.  

When you hold a bond, you’ll be taxed on the interest payments, and on returns from the original issue discount.  For a bond with an original issue discount, even if there are no annual interest payments, taxes are due as if the total gain were paid over the term of the bond – so there’s some work to do while you hold one. 

The most important thing to remember is to do your research and know what you’re getting yourself into when you purchase an asset.  Understand the risks and weigh them against your risk tolerance.  But don’t be overwhelmed.  The SEC requires publicly-traded companies to issue mountains of guidance about their performance, and although it can easily seem like a pile of finance-speak, it’s only a starting point.  There are countless resources available to research stocks and bonds, particularly if you’re buying ones issued by well-known companies.  Remember, invest long-term (to the extent possible) to mitigate risk and only undertake investments within your comfort range.  Like anything, the more you do it, the more comfortable you’ll get.