CHAPTER: SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM



CHAPTER: SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

Imagine you came into some money and sought out an advisor to help invest this windfall in stocks and bonds. One of the first questions he would ask you is how much risk you’re willing to tolerate. Stocks are riskier than bonds, so they make sense for someone willing to bear risk for the reward of higher expected return. But for a very risk-averse person, the adviser would likely recommend a larger allocation to bonds.

This naturally leads to the question: Why are stocks riskier than bonds?

When we say stocks are risky, we mean that the return on holding stocks is more volatile than the return on holding bonds. In other words, the gains and losses can be bigger. The reason for this difference in volatility is that stocks and bonds are different kinds of claims on the corporation that issued them.

Stocks represent ownership in the corporation, and the stockholders share in the firm’s profits. If the firm has a good year, its stockholders might enjoy large dividends. If the firm’s profits are low, then stockholders might not get any dividend at all.

Bonds, on the other hand, represent the firm’s indebtedness to bondholders. If the firm has a good year, bondholders do not share in these extra profits. If the firm has a bad year, it still pays the same amount of interest to bondholders, unless the year was so bad that the firm has to default on its debts.

So the income from owning stocks is more volatile than the income from owning bonds.

I should mention that many stocks provide no income until they’re sold. Shareholders of Amazon-dot-com and Starbucks have yet to receive a dividend, for example. But people are happy to hold such stocks if they expect to sell their shares for a higher price than they paid.

Of course, those future prices depend on expected future profits. As a result, stock prices are very sensitive to any news that alters people’s expectations of a firm’s profits.

Each day brings news that makes people revise their expectations. So stock prices tend to move unpredictably. We will learn more about this in the next chapter. But for now, the point is that these unpredictable movements in stock prices explain why stocks are riskier than bonds.

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