So My Hipster Barber Asked What is a Stock and a Bond in Simple Terms

Some Basic Explanations

I often forget how some obvious concepts in my head are quite foreign to other people…. this hit me this weekend when my Hipster Barber acknowledged he knew nothing about stocks and bonds but should given the (correct) perceived need to save and invest for retirement. The below is what I told him and others that have asked for a similar explanation.

First Let’s Describe an Investment Property

An explanation is always helpful with an analogy. Here we go:

1. You own an investment property worth $200,000 in a Corporation
2. The property has a n interest only mortgage of $120K on it
3. You paid $80K out of pocket to buy the property
4. The property has rental income of $12K net of expenses

A Bond

A bond is simply a security that is sold to investors that provides interest payments over a set period of time. A bond is not exactly like the $120K interest only mortgage but it is pretty close.

The investor takes on interest rate risk and default risk on the bond. While the seller of the bond gets principle and assumes payback risk. A bond is first in line to take over the rental property if the corporation doesn’t pay. There can be some different “layers of debt” with some debt more senior than others. Some debt is secured by physical goods (eg the house).

Interest rates are usually fixed on bonds (called the coupon) and they have a fixed period of time (or maturity date). The interest rates can float but most bonds have a fixed interest rate.

Interest Rate risk taken on by an investor is typically expressed with Duration which explains for every 1% change in interest rates, the impact on price of the bond given its coupons and maturity date. A bond with a duration of 2 would have a 2% swing in its value. If interest rates go up (the investor gave you too good of an interest rate), the principal value of the loan/bond goes down as the cash flows are worth less than a comparable bond and supply/demand push the bond to equilibrium. The reverse is true if rates go down (bond value goes up as the investor locked in a good interest rate).

I spared you from the different types of Duration…they basically all mean the same thing.

A bond can be bought and sold until it matures….. if you have ever owned a house with a mortgage you have seen likely seen your mortgage change hands.

A Stock (Sometimes Referred to as Equity)

When someone says “stock” they are typically referring to one share of a publicly traded company. Each share of stock represents a piece of the business which has the right to the cash flows and appreciation of this business.

A stock does not have to be publicly traded to be a stock – example would be Uber who is 100% privately owned – the investors are invested in a non publicly traded stock.

Going back to our example if you bought the investment property above you put in $80K of equity into the property. If your corporation by laws stated there were 10,000 shares in the corporation and you own all of them – the price per share would be $8.00. What does that $8 a share represent? It represents 0.0001% of the company (1 divided by 10,000). If the house investment pays out a $10,000 dividend you would get $1.00. If the house appreciates in value, your share price increases. If the investment property is able to pay off all the debt your $8.00 a share should go up to $20.00 ($200,000 property with no debt divided by 10,000). If the property goes down in value or debts can’t be paid your share price could go down…… the value of your stock in theory can go to zero.

A stock gives you the right to current and future cash flow and your level of risk is determined by 1). What price did you buy the stock? Did you buy the stock at $4 or the current $8? 2). Is the business healthy – can the company pay its bills, issue dividends, and reinvest in the property to ensure the house value goes up and rental payments go up?

A stock can be sold to a secondary party. Non-public companies obviously would have restrictions on how this is bought and sold.

There can be different “layers” of stock with seniority as well as bonds that can also convert into stock…. people have gotten creative over the years. A company may also decide to issue more shares of equity vs issuing bonds which may impact the stock price but typically does not as share issuances are typically completed at a share price close to the current shareholders for both public and private shares.

Differences

A stock (or equity) as you can see above is a different type of risk than a bond.

A bond is focused on more “tangible” elements – What interest are you going to pay me? Over what time period? Cash flows are known. Default risk and interest rate risk are the primary risk factors

A stock is focused on an ownership stake in the company which gives you rights to current and future cash flows but all stockholders are treated equally on distribution unless there are different classes of stock (you just may have more shares). Cash flows are not known (dividends are not guaranteed) and share appreciation is dependent on how well the company executes and the overall market (if houses are generally worth less in the example above – your stock value would go down). Company specific risk and macroeconomic risk are your risks.

Defining what you are trying to financially achieve with an investment will ultimately dictate which investment is right for you.