There was a time, several decades ago, when Hainanese chicken rice establishments in Singapore served only one type of poultry - the plain boiled variety. You could have almost any part of the chicken's anatomy that you wanted. You really could. But the chicken was always boiled. Then something changed. Roast chicken was introduced, which provided diners with a choice of either brown or white chicken. Purists claim that it should always be the boiled variety. But who's to say that those who like the texture and fragrance of roast chicken are wrong?
Something similar happened in the investing world. Years ago, the only product available to investors was government stock. Investors could lend money to a government, for which they were paid interest. That quickly expanded to include loans to companies. They were paid interest on those too. But it didn't take long before investors wanted more than just interest - they wanted a share of the profits that the companies made. The argument at the time was logical: If investors trusted a business enough to lend it money, then they should also trust it enough to own shares in it. And that was the beginning of the share market.
Today, investors can choose between a plethora of bonds and a myriad of shares. Some investors like bonds, some like shares, while some like a bit of both. But it is important to understand the differences between them. Admittedly they both generate income, which is why they are called asset classes. But it is the way in which they generate the income that matters. Additionally, the mix of bonds and shares that we have in our portfolios can affect the overall performance of our investments.
Shares are equity. As a shareholder, we are a part-owner of the business. We are entitled to have a say in the way the company is run; we have a right to vote on certain matters and we also have a claim on any profits that the company makes in the future. But we also have to stomach any losses that the company might incur. However, the most that we can lose is the amount of money that we have invested in the business. So the upside is we get to share in the growth of the company. The downside is we could lose our investment, if the company should go pear-shaped.
Bonds are debt. When we buy a bond we are effectively lending money to either a company or to a government. Put another way, we become a creditor to the government or the business. We even appear on the company's balance sheet as a liability because it owes us money. The terms of the loan are clearly defined at the outset. So, bondholders should know exactly where they stand in terms of when interest is paid and when the loan will be repaid. In other words, the start and end point of the loan agreement is normally fixed. That can be a big advantage because we can calculate our returns with some certainty.
But the main advantage of being a bondholder is that you have a higher claim on the assets of the company, if things should go badly wrong. In the case of a total failure or a bankruptcy of the business, the bondholder will get paid before any shareholder does. But the shareholder might not go away totally empty-handed. The shareholder will get anything that is leftover, which could be something or nothing.
The difference in the level of risk that bondholders and shareholders take on is reflected in the returns that the two types of investors could expect. The risk that a bondholder assumes is generally lower than that of the shareholder. So, it is understandable that the bondholder should get a lower return. Similarly, it is not hard to fathom why shareholders could do better. As a company grows bigger and more profitable, shareholders could participate in the increased profits, as the dividends are raised. Of course, the returns are not guaranteed, which is why shareholders expect higher returns than bondholders.
The decision as to whether to invest in bonds or shares is one of those old hoary chestnuts that will never go away. There is no right or wrong answer, unfortunately. Some people believe that a properly diversified portfolio should have a mixture of stocks and bonds. Additionally, it is reckoned that the amount of each should change over our lifetime, as our tolerance to risk might go from risk-tolerant to risk-averse.
That makes sense. But the downside with holding too many bonds is a lower return. Or as Peter Lynch once quipped: "Gentlemen who prefer bonds don't know what they are missing."
It's a tough choice. But for me, it's easy. I don't like roast chicken.
- This is a regular monthly column on stocks and investing by David Kuo, chief executive officer of The Motley Fool Singapore.
This article was first published on April 4, 2016.
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