Bonds are supposedly less risky to
invest compared to shares. This is so because in the unfortunate event of
business insolvency/bankruptcy, the bond holder (investor in bonds) comes ahead
of the equity shareholders in terms of payouts should the entity be made
insolvent. On the other hand, the equity investor is last in line to be paid
and more often than not business failure to an equity investor equates to an
almost certain loss of their entire capital that he/she has invested in the
failed business. With respect to bonds, the bond holder is promised by the
party receiving the money (the Issuer), to repay the face value of the bond
(the principal) at a specified date (maturity date.) In view of this, it becomes
apparent that capital is more exposed to risks when it is invested in shares
rather than bonds.
In terms of providing an income
there is also a distinction between shares and bonds. In the latter, the
investor in bonds is often provided with fixed yields, the main advantage here
being that he/she is able to predict income from their investments. This is an
attractive feature for investors approaching retirement, when regular income
from their investment is more favorable investment strategy than exposing their
capital to higher risks.
For example, if an investor where
to buy a bond with say 10% coupon at its 1,000 USD par value, the yield is 10%
(100 USD/ 1,000 USD). That seems straightforward. But the investor in
bonds needs to bear in mind that the price of bonds fluctuates on the bond
market. So assuming the bond price goes down to 800 USD, then the yield goes up
to 12.5%. This occurs because the investor receives the same guaranteed 100 USD
on an asset worth 800 USD (100 USD/800 USD).
Conversely, if the bond goes up in
price to USD 1,200, the yield shrinks to 8.33% (100 USD/1,200 USD).
Shares do offer income to the
investor in terms of dividend payments, but income from this is not
predetermined and can be unreliable. Note that dividend payments on
shares usually depends on the performance of the company throughout its
financial year and the amount of income paid, if any, is recommended by the
company’s board directors. So the investor has no real way of deriving a stable
income from shares. In some years the shares may pay dividends, whilst in other
years, little or no dividends may be paid out.
Despite the uncertainty of income
that shares offer investors their main attraction as an asset class is their
potential to offer the investor capital growth. However, the general rule of
thumb for investing is applicable in share investing, that being the higher the
potential risk to the capital the higher the rewards received by the investor
and visa versa.
In other words, there is a
positive relationship between rewards and risks.
If the investor is willing to
forsake higher risk for the potential of greater returns, then equities may be
the suitable financial instrument for him to achieve his goal. This is one of
the main advantages of share investments compared to bonds-the potential of
capital growth. A young investor, a long way from retirement may prefer
an investment strategy where their investments are more geared towards growth,
rather than immediate income. This means that their investment portfolio may be
orientated more towards shares rather than bonds. So the investment goal
of the investor could determine whether investing in bonds is more suitable
than shares.
Indeed, volatility is another
distinction between the two financial instruments. Share can fluctuate widely
on the future potential profitability of the business, on the expected
earnings. Technology stocks, pharmaceutical stocks investigating in new
drugs for say cancer, or prospecting oil/ mining stocks share prices have the
potential of gyrating widely on the stock market based on the prospects of
positive events influencing the company’s profitability. Investing in
these types of companies before the positive event has been factored into the
share price offers investor the potential of large capital gains. A photo
looking like a bunch of long haired hippies, featuring micro soft founders in
1978, states, “would have you invested.”
If an investor were fortunate
enough to have bought 100 shares at 21 USD in MicroSoft in 1986, an investment
2,100 USD, those shares over the course of nine stock piles would have
mushroomed to 28,800 shares. Assuming the investor then sold those shares in
December 1, 1999 he would have bagged a massive 1.4 million USD. Sure,
this is easier said than done, but no doubt this will probably wets the appetite
for shares, even amongst the diehard cynics among you.
Another bonus of share investing
is that the investor owns a piece of the company. There are different classes
of shares with different voting rights. Shareholders are invited to attend
annual meeting of the company, they can vote on issues that influence the
business, such as takeover and acquisitions of the business, changes to members
of the board. Naturally, the larger the shareholdings in a company the more
voting clout the shareholder investor has in selecting senior executives who
will run the company and voting on import issues that could influence the
business. In contrast, a bond holder doesn’t acquire ownership in
the business; they have no voting rights and no way of influencing the business.
So the theory goes that bonds are a supposedly the
safer bet than shares-they are the more preferred asset by the grey haired
people among us. But so is gold considered the ultimate safe haven, the
ultimate rat hole to climb into when things go pair shaped. Despite this common
held view gold investors eroded 28 percent of their capital in 2013, it was the
worse year for gold since 1981. Bond investors also experienced the worse year
in living memory in 2013. Indeed, playing safe last year has left some
investors feeling very sorry for themselves, but will the appetite for risk
continue into 2014…?
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