Part 2: Stocks, Bonds, and Cash: A primer on asset classes

Editors Note:
Burt Mayer, a senior at Lakeside High School in Seattle, WA interned at Merriman this summer with the intention of creating educational material for young investors.  This three part series featured on FundAdvice.com is perfect for those investors who are looking to get started but need to know the basics first.

Investors at all levels spend a tremendous amount of time and energy looking for hot stocks and attractive funds. They track fancy-looking graphs and complicated ratios because they’re fancy looking and complicated. Ultimately far more time is spent thinking about individual stocks and bonds than what percentage of their money is invested in stocks versus bonds.

Meanwhile, many academic studies by very smart people have concluded that the way we distribute investments across asset classes is far more relevant to a portfolio’s return than the specific securities or funds in that portfolio. A famous 1986 study by Brinson, Hood, and Beebower (he’s the smart one) called “Determinants of Portfolio Performance” concluded that a full 93.6% of the variation in a portfolio’s quarterly returns can be explained simply by what proportion of the portfolio is put in different asset classes.

In light of Beebower’s study (22 years ago) I’ve decided to devote an article to explaining what the different asset classes are, how they work, and most importantly, how you can make money with them.

Investment Vehicles

Wall Street gurus often seem smarter and more knowledgeable by referring to stocks, bonds, and cash equivalents as more fancy-sounding words like equity, fixed income, and money market instruments respectively. For this reason I too will refer to them as equity, fixed income, and money market instruments.

Equity

Put simply, equity is an ownership position in a publicly traded corporation. Every share of stock corresponds to a piece of the company. How much of the company you own can be calculated by dividing the number of shares you’ve purchased by the total number of shares the company has issued. For example, if I own 50 million shares in Victoria’s Secret’s parent company Limited Brands Inc., which I happen to know offhand has issued 340.34 million shares, then I effectively own 14.7% of said secret.

Owning part of a corporation comes with certain rights:

• All investors have the right to receive a proportional share of their company’s profit should it choose not to retain all of its earnings. Most corporations choose to keep some of their profits and reinvest them back into the company, which usually benefits the shareholders as it can likely raise the share price. Yet usually they will also send some of their profits back to their investors in the form of dividends.
• Shareholders have the right to participate, at least indirectly, in their company’s decision-making. Obviously it would be extremely inefficient for a company to refer back to its shareholders every time it wanted to do something, so instead the shareholders vote (usually 1 share = 1 vote) every year to decide who sits on the company’s Board of Directors, which is the decision-making body.

While owning a piece of a company can feel pretty exciting, the real reason for buying equity isn’t the right to contribute to corporate decision-making or even (usually) the right to a share of the profits. We buy equity so that when a company or a fund gets stronger and grows in value our money will be along for the ride. As a company gets more valuable, so too does our ownership in that company get more valuable. The buying and selling of these shares of ownership are the basis for what we call the stock market.

It’s important to understand, however, that in the short-term companies go down in value almost as much as they go up. Losing money in equity can be exceedingly easy, as few investment vehicles are as risky or volatile as a bet on the future success of a business. Packages consisting of lots of different stocks, called mutual funds, are one way of exposing yourself to the high returns of equity while reducing the risk.

Fixed Income

Just like my friends, companies often ask to borrow money. The IOU’s that they give in return for your loan are called bonds. Most bonds promise not only to repay your initial loan to them, called the principal, but to give you some interest, called the coupon, every year until the loan expires, at which time the bond is said to have reached maturity.

Unfortunately, also like my buddies, sometimes companies break their promises. If a corporation goes bankrupt they’ll likely default on some or all of their debt and your fixed income may lose all of its value. Why, in that case, would anyone loan their money to a sketchy-looking business? The more unstable a company looks the higher they’ll have to pay in interest rates to get loans and the more money you’ll make from owning their fixed income (should they stay in business).

The value of a bond is dependent on several variables:

• The amount of the bond’s principle (typically $1,000) and the date of its maturity (when you’ll get paid back).
• The stability of the company issuing the bond.
• The amount of the bond’s coupon.
• His ability to effectively execute top-secret missions.

Bonds can be bought, sold, and traded just like stocks.  However, fixed income and equity often move in opposite directions. For this reason, owning some of both can even out the bumps in both markets and provide a more consistent growth in a portfolio.

Money Market Instruments

The best way to avoid the risk inherent to both equity and fixed income is to leave the “capital market” and enter the “money market”. The money market is used for borrowing and lending money with a much shorter time-horizon, almost always under a year. Money market instruments are therefore characterized by being short-term, liquid (easy to get out of), and very safe. Some common examples of money market instruments are commercial paper (very short-term bonds issued by large corporations), certificates of deposit, and treasury bills (short-term bonds issued by the U.S. government). They’re sometimes called “cash equivalents” because they are almost as secure as currency and quick and easy to turn back into cash.

Historical Performances

There are dramatic differences between the risk levels of stocks, bonds, and cash: Clearly a share in a company is riskier and more volatile than a long-term loan to that company, which is in turn riskier than a short-term loan to the U.S. government (which tends not to break its promises). However, differences in risk almost always equate to long-term differences in return.

Here are the annualized growth rates for these asset classes between 1925 and 2000:

Equity: 11%
Fixed Income: 5%
Treasury Bills: 3.8%
Inflation: 3.1%

Keep in mind that an inflation rate of 3.1% means that money market instruments effectively gained only 0.7% in value each year. In most bank savings accounts your money actually loses value as it can’t beat the rate of inflation.

Asset Allocation for Young Investors

Investing in equity can be extremely risky and volatile, but the best time to be taking those risks is when we’re young. We have an enormous advantage over older investors in that we won’t be dependent on our retirement funds in the very near future. We have the ability to allow our retirement money to drop significantly in value any given year, and so we can experience the high rate of return that equity has historically yielded over the long term.

Investors in their teens and early 20’s should have at least 80% of their assets in stock (the other 20% being in bonds) and maybe even up to 100% providing that they’re comfortable with the level of risk that entails. I personally believe (from my many years tracking U.S. equities) that anyone with 100% exposure to stock should be willing to lose ⅓ of their money in any given year. They should know that with a long enough time horizon any one drop in the market will largely become insignificant.  But in the heat of the moment it can be hard to lose that much of your savings and still stay in the game. Trust me, ignore the market timers, business news, and financial magazines – always stick with your plan.

The trouble with an all-equity portfolio is that it likely will fluctuate pretty significantly, and so in any given year you might not have the money you hoped for. This is why it’s important to invest differently depending on how long a timeframe you have in mind for your investment. When investing for your retirement 40 or 50 years in the future you can handle the short-term ups and downs of equity, but if you’re saving for something only 5 or 10 years from now you wouldn’t want to take nearly as much risk. Money market instruments won’t grow in the same way that equity or even fixed income could, but at least you know you’ll have your money when you need it. As retirement approaches, adults are similarly advised to shift up to half of their money from stocks to bonds, and to shift their funds for immediate living expenses all the way to cash equivalents. After all, you wouldn’t want your successful, yet risky portfolio to take a serious dive right before you need it most.