Stock Vs. Bonds - Essay Example

STOCK VS. BONDS al Affiliation) Key words: Bonds, Stocks Stocks have historically had much higher returns than bonds. Can these excess returns be justified by the higher risk attached to stocks, or are there alternative explanations? In assessing whether stocks have higher risks when compared to stocks, it is possible to arrive to justifiable explanations based on a comparative analysis. In this regard, an assessment can best be viewed when analyzing portofolios that are engaged in 100% bonds versus portofolios that are 100% stocks (Nicholson, & Snyder, 2009). Evidently, stocks exhibit more risk when compared to bonds for short term investors. However, for individual engaged in long term investment, historical and actual returns show that bonds exhibited more risk when compared to stocks. However, before delving further into this economic argument it is best to first of all understand the definition and composition entailed in the term ‘risk.’ This is because there has been a general misconception and understanding of the term ‘risk’ more so among long term investors. In this regard, much of the literature regard the term ‘risk’ is misconstrued and totally misleading to long-term investors. This is somewhat due to the over reliance and stressing on ‘short term volatility’ (Nicholson, & Snyder, 2009). According to the definition generally accepted by the investment community and long-term investors, risk is regarded as the volatility return accrued from an investment in the short term of daily, annual or monthly. Evidently, the measurement for volatility of returns is either by standard deviation or variance. From this perspective, the definition offered is flawed in relation to a long term investor for two reasons. Foremost, the conclusions and analysis drawn are reliant on nominal returns while blatantly paying no attention on the erosion of purchasing power instigated by inflation (Nicholson, & Snyder, 2009). In the case of investors in the short term, inflation is not a significant concern but of high impact during the long-term. The second flaw is that the conclusions and analysis drawn more than often place an emphasis on the volatility of daily, monthly or annual returns. In the case of many investors, a focus that is based annually maybe more appropriate. However for long-term investors, their concerns should me mostly focused on risks consistent with their long-term wealth parameters and not basically focused on the short term pitfall along the way (Nicholson, & Snyder, 2009). Evidently, stocks provide higher return potential when compared to bonds. However, they accrue a greater volatility in the process. The major questions arising from this precint are; why do stocks produce more returns when compared to bonds? Moreover, why is it that bonds exhibit less volatility? To better understand the reasons behind the posed questions, it is advisable to undertake a basic case study example. The basic example is an individual seeking to start up a business venture. The businessman is the sole employee and owner of the business. By capital needs, the businessman needs $2000 to commence operations but he/she only has $ 1000. Consequently, the businessman borrows the deficit of $ 1000 from a business friend with a promise to payback $100 every year within a 10 year period. By that time the businessman will have completed the full $ 1000 loan advanced. In the first year the business gains $500. The businessman repays the first $ 100 of the loan advanced after paying off his/her expenses and salary. He/she is left with $ 400. By financial implications, the business friend has earned (100/1000) that translates to 10% on his loan to the businessman. On the other hand, the businessman has earned (400/1000) that translates to 40% on his investment. During the subsequent year, the business does not perform optimally well after paying out all the expenses. Incidentally, the business has only made a profit of $ 100. The businessman proceeds to pay the business friend with the $100. This essentially means that the business friend has earned a 10% gain, However, the businessman is consequently left with a 0% return. This is despite the fact that within the two years, the businessman has achieved an approximate 20% return per year. Each subsequent year, the businessman has the opportunity to earn higher or lower than the business friend who provided the loan. In the event that the business achieves higher success, the business will accrue returns that are exponentially greater than that of the business friend. However, if the business falls through, the businessman stands to lose everything. Taking note that the loan advanced was a contractual agreement, and in the event that the businessman has to close down the business, all leftover cash first of all goes into paying out the business friend’s loan. In such a scenario, the businessman is evidently at a position of higher risk. However, the businessman retains the opportunity of attaining a higher return. Consequently, if the businessman did not have the opportunity of attaining a higher return, it would be illogical for him to agree into the higher risk. As in the example case provided above, bonds are basically loans. In this regard, funds are loaned by investors to governments or companies. In exchange, the investors expect a bond that offers a guarantee of a fixed return as well as an assurance of return of the principal also known as the original loan amount in a specified time in the future (Nicholson, & Snyder, 2009). On the other hand, stocks are basically fractional tenure rights in the company that permit the shareholder to partake in the ownership that arise and accrue. Incidentally, part of the earning can be paid out at once as dividends, while part of the earnings is retained. In this regard, the earnings that are retained can be ploughed back within the company to create a greater infrastructure. The implication being that the in the future, the company attains a potential opportunity to create even higher earnings. Another part of the retained earnings can be maintained for future uses such as making calculated acquisitions or purchasing back company stock (Nicholson, & Snyder, 2009). Irrespective of the use employed, in the event that the earnings continually grow, the stock price will equally increase as well. In essence, stocks have in the past accrued greater return when compared to bonds because as exemplified in the case, there is larger risk that, in the event of failure of the company, all the investments by the stockholders will be lost. However, on the flip side of things, there is the opportunity of higher returns to the stockholders that could be significantly greater when compared to earnings from bond investments. Stock investors evaluate the amount they are agreeable per share on the precinct of the supposed risk and the projected return potential. This return potential is fuelled by the growth of earnings. The stockholders are primarily balanced as a group and consequently will standardize their investments in a method that sufficiently pays them back for the high risk of their shareholding. When comparing bonds to stocks, it is evident that bonds guarantee a branded and fixed return rate. However, it does fluctuate in value hence influencing its volatility. There are several causes that make bonds volatile (Nicholson, & Snyder, 2009). Foremost is the time value of money and inflation. In this regard, the initial issue is anticipated inflation. Consequently, the greater or minimal the expectation on inflation, the greater or minimal the yield or return demanded by the bond buyers. This is largely attributed to notion regarded as the time value of money. Incidentally, it concerns the understanding that the value of a dollar today will have minimized over time due to inflation. Consequently, to predict the future dollar value in the present, an investor has to discount the dollars’ value at a specified rate back over time. The bond value in the present can be calculated by discounting the bond future payment. This discounting should be both in the type principal returns and payments from interests. Consequently, the greater the anticipated inflation, the rate of discount that must be applied will equally be higher. This will in essence arrive to a minimal present value. Moreover, in the event that the payment is farther out, a longer rate of discount will be applied. This will essentially result in a minimal present value. In this regard, as much as bond payments are predetermined and recognized, their payments are subjected to a continuously discount rate that changes based on the consistently changes in the interest rate. This hence translates to a continuous present value that varies and fluctuates. Since the original payment plan of the bond is permanent, its present effective yield will be changed based on the fluctuating bond price. Consequently, there is a rise in the effective yield based on the falling price of the bond. On the other hand, the effective yield will minimize based on the rising bond price. Evidently, the application of the discount rate is not primarily a utility of inflation prospects only. In the event that the issuer of the bond defaults in making payments on the interest, a subsequent increase in the rate of discount will be applied. This will consequently affect the present value of the bond. Incidentally, rates of discounts are subjective. The implication being that investors apply different and varying rates dependent upon their own assessment of risks, and projections on inflation (Nicholson, & Snyder, 2009). The current bond value becomes the consensus arising from the different calculations. In assessing the return from stocks, it is referred to as the free cash flow. However, in practice, reported earnings are given a more center of attention in the market. Evidently, such earnings are changeable and indefinite. Consequently, their growth maybe fast or slow, negative or shrink or not grow at all. In calculating the current value, the investor is expected to hypothesize what the earning will be like in the future. The situation is further complicated by the fact that the earnings do not possess a permanent life. Consequently, there is a possibility of continuation for a long time. In regards to the consistently changing projected return flow, the investor applies a consistently changing rate of discount. There is a remarkable high risk of volatility on stock prices in comparison to bond prices. This is attributed to two factors that are consistently changing. These are the rate of discount and the earnings stream. Majority of bonds and stocks are priced in a rational manner. The participants in the market subject their aggregate knowledge and best estimates in relation to risk in the future, future inflation, unknown or known income plans to ascertain the contemporary expectations. An in depth look reveals that emotions can effect these expectation and consequently incorrect valuations. However, in most scenarios the valuations are correct subject to the known element at any stated point in time. In conclusion, on average bonds will always exhibit less volatility when compared to stocks. This is majorly because there is a higher certainty and comprehension about their flow of income. On the other hand, stocks are bound to create higher returns when compared to bonds due to the high incidence of unknowns. Consequently, the higher the incidence of unknowns, the higher the potential risk. In the event that stock do not offer more returns, the implication is that the investors are controlled by irrationality in their actions and pursue senseless risk with money for investment. reference Nicholson, W., & Snyder, C. M. (2009). Intermediate microeconomics and its application (10th ed.). Cengage Learning: Thomson/South-Western. Read More