An Introduction to Stocks and Bonds

Americans have had a love affair with stocks and bonds for the longest time. The stock market is one aspect of investing that nearly everyone has heard of. Recently, the market has done exceptionally well--as a result, people's interest has been piqued. The stock market has definitely had its ups and downs. Like the gold rush, the stock market has periodically made people feverish. In the process, it has made millionaires and ruined many people. Historically, stocks and bonds have been the #1 and #2 investments respectively. Nothing has outperformed them in the long run.

Learning all the nuisances about stocks and bonds can be infinitely complex and can take years. The purpose of this section will be to familiarize you with some key aspects common to both stocks and bonds so that you understand a little more about what makes them tick!

A Brief History

In a period from 1925 to 1992, common stocks gained more value than both long-term government bonds and T-bills. This is despite such setbacks as October 1987 and other downturns in the stock market. One dollar invested in the stock market at year-end 1925 would be worth, with dividends reinvested, $727.38 at year-end 1992; this phenomenal gain came with great risk, though, especially through the late 1920s and early 1930s. In contrast, a much less risky investment of one dollar in long-term government bonds (with a constant 20-year maturity) would be worth $23.71.

For investors seeking a completely risk-free repository for their money, U.S. Treasury bills have long been the favorite. Though safe and backed by the full credit of the United States government, T-bills have the tendency of tracking inflation, and therefore the inflation-adjusted investment return of T-bills is near zero for the period between 1925 and 1992.

Annual Returns on Investments

There are two mathematical indicators of annual returns on an investment: arithmetic means and geometric means. Suppose $1 were invested in a common stock that fluctuates between +50% and - 50% returns every year. After the first year, the portfolio is worth $1.50. After the second year, it is worth $0.75. The arithmetic mean of the two years’ return is 0, while the geometric mean (compound return) is -13.4%. The geometric mean more accurately represents the change in wealth over more than one period. However, the arithmetic mean is useful in representing the return over a single annual period.

Risk vs. Reward

There is a clear relationship between risk and reward that is evident in every investment vehicle. The greater the return an investment gives, the more risk that is involved. For more comprehensive information, see risk vs. reward in the mutual fund section.

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