Episode #36 - Bonds, Stocks, and History
Boats, Wal-mart,
Intro:
At the outset of this new project, I assumed I could simply summarize a chapter or two on a weekly basis. For what it is worth, I don’t think this book is something that can experience that simplification. I’m going to take it chapter-by-chapter and bit-by-bit to ideally give you this inside track in understanding investing. “No Guts, No Glory” (this chapter’s title), comes with a number of priceless quotes and metaphors. My favorites is:
Ultimately, this book is about the building of investment portfolios that are both prudent and efficient. The construction of a house is a valuable metaphor for this process. The very first thing the wise homebuilder does, before drawing up blueprints, digging a foundation, or ordering appliances, is learn about the construction materials available.
Of course in the world of investing, these materials are stocks and bonds - topics the die-hard #Winnings readers recall from past episodes. This chapter takes us through 5,000 years of human history (possibly even further) to set the stage of markets, loans, and most importantly the impact of risk on rate of return.
Content:
Starting with Ships: In ancient Greece, one mode of business was a “bottomry loan,” a maritime loan that would be lost if the boat sank. This was basically a bond. Helpfully, the historical record is quite strong for these loans and researchers have found that the interest rates during peacetime was around 22.5% and it was 30% in wartime. According to the research, it is likely that fewer than 10% of ships were lost, making these solid bets if you placed many of them, but risky if you just looked at it from a case-by-case basis. The added lesson here was that uncertainty raised the rate of return for the risk taker - 22.5% interest was high even for that period in history. Think about it, this was pre-GPS, radar, and all of the other things that make Suez Canal mishaps the exception and not the rule.
Interest rates in ancient civilizations follow a U-shaped curve, when the civilization begins the rates are high because we don’t know if the nation will succeed, at the apex of the civilization the rates are super low, and then as the nation falters, the interest rates go back up again. Does that apply to today? We might find out…
Sidebar: Bernstein reminds us that there is a tremendous survivorship bias to most historical finance data. They were successful so they were able to leave a record. Think about it, how much do we know about Carthage’s finance? Little - they weren’t super successful on that front.
We’re introduced to “credit risk” - the risk that the item you’ve invested in because the debtor, the person/government you lent money to, will fail (sunken ship, country overrun by barbarians - again this is the history component of the book). This is opposed to “interest-rate risk” - this is your investment becoming devalued because the interest rate decreases. Today, Bernstein explains, this is effectively the same as inflation risk. He provides the 30-year Treasury Bond example, biggest risk there is that inflation will make your future interest/principal payment worthless.
Still on the topic of bonds and history, this chapter covers the transition of the US off of the gold standard to paper currency. Basically until WWI, gold=money. If you’re lucky, you may have even seen some of these gold coins that are still legal tender - a quarter, worth $2.50, a half, worth $5, a full, worth $10, and a double, worth $20. Today, the quarter that could buy you a bottle of coke for $2.50 is worth closer to $35 of the actual gold value. Why does this history matter? It places the 20th century as possibly the worst time for bond-holders. Because countries could just PRINT MONEY and not need to back it up with gold, the value of bonds plummeted.
What’s the advantage of stocks over bonds? While you might have a bad run with stocks they eventually recalibrate, bonds do not have the feature of reverting to the mean. This means that bonds can have a series of bad years that are followed by more bad years. If you’re following along in the book, you’ll deeply benefit from the charts included.
Essential counterintuitive investing concept: Why Kmart is a better investment than Wal-mart? This might come as a surprise. Remember, Kmart has oft been in the news with bankruptcy and other issues, while Walmart sits on a boatload of money. What gives? This is a chance to learn stock parlance: “growth stocks” - consist of good companies, like Wal-mart, and “value stocks” - typically bad companies, like Kmart. Since Kmart is much riskier than Wal-mart, your returns for investing in Kmart, assuming it turns around, is much higher than the upside for Wal-mart. Ponder this for a little longer because it’s important! The growth company will just have less overall upside than the value company. This isn’t an endorsement of which of the two you should buy, just a way to understand the difference between them.
Takeaway:
Essential things to remember:
Expect at least one, and perhaps two, very severe bear markets during your investing career. (p. 25)
Additionally:
High investment returns cannot be earned without taking substantial risk. Safe investment produce lower returns. (p. 29)
Interact:
What is a growth stock that you follow?
What is a value stock that you follow?
Please share them in the comments below!
Then I suggest you choose one of each to see which does better over the next six months. You can check back at the comments to see what happened.
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Please remember, I’m not providing professional advice about personal finance. I’ve got a lot of friends who do that and you can totally hit me up for an intro if you’d like - I don’t get any commission - just the happiness that my readers are taking their financial health seriously.