Wednesday, July 30, 2008

Investing basics - stocks

Yesterday, we learned that investors who buy bonds are essentially lenders.  Stocks work differently.  Investors who purchase stock in a company become partial owners of the company.  A share of stock represents ownership of a very small fraction of a company.  There is no predictable rate of return for a stock.  If the company does well over time, the stock tends to do well over time.  If the company does poorly over time you can probably guess what happens.

Stock holders make money in two ways - through dividend income and through the increase of the share price.

Some - but not all  - stocks pay a dividend.  This dividend payment is a cash payment made to anyone who owns a share of the stock.  Dividend payments from stocks tend to be at much lower rates than bonds.  However, stock dividend payments, unlike bonds, are not fixed.  Stock dividends can be increased, decreased, or eliminated.

Stock holders also make - or lose - money based on the price of the shares of stock that they own.  If the company that they own shares of does well or is predicted to do well, the share price will rise.  If the company does poorly or is predicted to do poorly, the share price will fall.  From 1900 - 2000, U.S. stocks provided investors with an average annual return of 10.1% (this includes the dividend).  For that same time period, U.S. Government bonds provided an annual return of 4.8%.  It is very, very important to keep in mind that these examples assume that all dividends and income from these investments is reinvested, not spent elsewhere.

While these returns may sound small, over time they really add up.  Hypothetically, if you invested $1,000 in government bonds in 1900 and your investment grew at 4.8% every year, in 2000 your investment would be worth $103,000 .  Not bad - you now have over one hundred times what you started out with.  However, an investment in the stock market over the same time period which returned 10.1% every year would be worth $15 million.   Sadly, you would probably be dead at this point.

Please keep in mind that the returns above are averages.  The performance of individual stocks is very different form the average performance of the market as a whole.  Lets look at two extreme examples and pretend that on January 1, 2007 you invested $1,000 in Crocs, the company that makes brightly colored foam shoes, and $1,000 in Krispy Kreme.  Hindsight is 20/20, and apparently, in 2007, people just couldn't buy enough colored foam shoes.  Crocs stock rose 168% in 2007.  This means that after only one year, your investment in Crocs is worth $2,680.  That would make anyone happy.  Krispy Kreme, however, had a tough year and the stock lost 72% of its value.  Your $1,000 investment is the doughnut maker is now worth only $280.  You probably would have been happier if you had spent your $1,000 on Krispy Kreme doughnuts rather than stock.  However, between the two investments you still came out alright.  You started with $2,000 and ended the year with $2,960.

Generally speaking, stocks are a risker investment than bonds.  Not only is a stockholder more likely than a bondholder to lose money on his investment, but that stockholder will also experience more volatility.  In the financial world risk generally refers to an investment's volatility.  Historically, given a long enough time frame, stocks have out performed bonds time and time again.  However, over shorter periods of time stocks can take a real dive while bonds chug along making money.  Because of these volatility differences, even if you believe (as I do) that stocks will continue to outperform bonds in the long run, there is still a place for bonds in an investors portfolio.

No comments: