Demystifying the common financial assets: Saving accounts, Bonds and Stocks
Once you look at them via a similar analytical framework of comparing across return, risk and liquidity, they all look familiar to each other.
In the previous post on this series of building wealth, we explored the dimensions of Risk, Return and Liquidity utilizing the example of government bonds to explain these concepts. These concepts can be used to compare and contrast almost all financial assets and demystify the complex jargon of bonds, equities, commodities, private equity, hedge funds that riddles the world of finance and make it seem incomprehensible to an average person.
In this post, we explore the common financial asset classes and compare these across the dimensions of return, risk and liquidity.
Bank Products / Saving Accounts:
The regular savings account at the bank is the most common, accessible and simple financial product for people to save. Parents have their children open accounts at the bank to save their pocket money. To access this, you walk up to your local bank branch to open an account, or nowadays simply download a mobile application and sign up digitally.
Return: The returns on savings accounts are the lowest across almost all asset classes. The return is explicitly stated by the bank as the interest rate or profit rate. The return is almost always lower than the central bank’s policy rate.
This gap below the policy rate is often kept to a minimum due to bank regulation in some countries whereas in others it’s not regulated and primarily driven by competition amongst banks for deposits.
The return offered on savings accounts is oftentimes below the inflation rate of the economy. Whilst people may still be earning interest and growing their saving pots in nominal terms, in real terms after adjusting for prices of goods and services going up due to inflation, people may be losing wealth by having their savings tied up in savings accounts.
Nonetheless keeping money in savings accounts or interest bearing accounts at the bank is still better than keeping cash at home or money in current/checking accounts.
Risk: In terms of capital risk, deposits at the bank are extremely low risk for most people. In modern financial systems, banks are highly regulated by government bodies to ensure they don’t lose the public’s money. In cases when banks can go bankrupt, financial regulators have deposit insurance and protection mechanisms in place to ensure the average depositor doesn’t lose money. The popular story of a robber walking up to a bank and stealing people’s money is also anachronistic since only a minuscule proportion of bank deposits are held in paper money at a branch. The majority of the bank’s money is now represented electronically in computer systems.
Deposits up to a certain limit ($250,000 in US / €100,000 in the EU / Rs. 500,000 in Pakistan) are insured by the government. Beyond these limits, there is a risk of depositors losing money if the bank goes bankrupt. This used to be more common in the late 19th / early 20th century but is increasingly rare in the 21st century due to financial regulators taking a more proactive approach in not letting banks go bust.
In terms of return risk, the banks are legally obligated to provide the interest rate or profit rate that they advertise. The interest rates can vary over time, even at short-notice, as the policy rate of the central bank changes.
Liquidity: The majority of savings accounts at the bank, with the exception of some specialized term deposits, are as liquid as cash. With debit cards, cheques and bank transfers tied to savings accounts, money in savings accounts can directly be used to pay for goods and services at any time. Savings accounts at the bank are the most liquid of return-generating financial assets.
Bonds
We covered bonds in much detail in the previous post. For a quick recap, bonds are a financial instrument issued by an issuer to borrow money from individuals or institutions at a fixed rate of return. Individuals or Institutions that buy the bond are called bondholders.
Bank deposits and bonds are debt products meaning that the issuer of these products i.e. the individual or institution borrowing money, is legally bound to pay back the money either over the contracted schedule in the case of bonds, or on-demand in case of bank deposits. They are known as fixed income products since the return is always known. The returns vary across different kinds of bonds and can be mathematically normalized to a single value called yield to maturity which takes into account the current price and face-value of the bond, the coupon rate and payout schedule.
Bonds are generally issued by several categories of issuers. These include:
Sovereign bonds issued by national governments.
Municipal bonds issued by local governments and civic bodies.
Corporate bonds issued by corporations. Corporate bonds are then further divided into:
Investment grade bonds issued by large, mature, profitable and stable companies with a strong track record of honoring their commitments and ability to sustain their market positions.
Junk bonds issued by smaller, riskier, earlier stage or unprofitable companies.
On a spectrum across categories, sovereign bonds are considered the highest quality with corporate junk bonds considered the lowest quality. Specialized Credit Rating Agencies issue quality ratings for a bond and its issuer. They take into account the contractual obligations of the bond itself and the issuer’s past financial performance, economic outlook and other factors to give a rating on how credible they find the issuer to be able to meet the contractual obligations of the bond. Lenders rely on these ratings to get an understanding of their credit risk i.e. the likelihood of the borrower defaulting on its repayment commitments.
The majority of bonds issued by national or local governments and large corporations follow standardized terms and are tradable on secondary markets. Separately from standardized bond offerings, specialized borrowers and lenders also engage in private credit placements where companies borrow from non-bank financial institutions or individuals, almost always high-networth individuals only. Private credit placements are generally used for borrowing capital by small-medium sized companies that find it harder to access the standardized market, or want to offer complex, bespoke terms. Institutions such as private equity funds, hedge funds or high net-worth individuals seeking fixed income returns higher than standard bonds lend in the private credit market.
Return and risk are inversely proportional to the quality ratings. Lower rated bonds are by definition riskier thus they offer higher returns to compensate for the increased risk.
Liquidity is proportional to quality ratings i.e. lower rated bonds are generally less liquid. Either buyers are hard to find at short notice, or the seller has to pay more in transaction costs to intermediary financial institutions to sell their bond holdings. Private credit placements are generally riskier, higher return and less liquid than standard bond offerings.
Public Stocks / Equities
Companies can be funded via debt capital i.e. by borrowing money from other individuals or companies with a promise to pay back the money over a definitive time period with a return on top; or via equity capital i.e. selling an ownership stake in the company. Shares represent a share or portion in a company’s equity capital stock. When you hold the shares of a company, you own an ownership stake in the company.
Whilst debt-holders are paid back a fixed rate of return on the money they lend to the business, equity holders are entitled to all the profits left over to the business after paying back costs, interest expenses and taxes. The company can choose to either return profits to equity holders in the form of dividends or reinvest the profits in the business which can lead to an increase in the value of the business and consequently the value of the shares in the business that the equity holders own.
A stock market is an institution where people buy and sell shares of companies listed on the stock exchange. The buying or selling on the stock market happens every second during the opening hours of the markets. If you want to purchase stock in a particular listed company or want to sell the stock you own, you can do so whenever you want via a broker which gives you access to the stock market. The buying and selling behaviors determine the price at which shares in a particular company are trading.
People rely on the prices determined in the stock market to measure the value of their equity investments, gauging the performance of their investment portfolio from the changes in price.
Return profile: Equity holders earn a return on the capital they invest via two main means. They earn a capital return when the value of their shares in the business appreciates in the stock market. They earn a cash return when the company pays dividends to its stockholders.
Say, on 1st January, you invest $1000 to purchase 100 shares of ACME company for a price of $10 and hold it for the entire year. On 1st June, the company paid out a dividend of $2 per share. By 31st December, due to the strong business performance over the year, the ACME company shares were trading at $13. On your initial $1000 investment, you would have earned $200 in cash dividends, and $300 in capital returns when your 100 shares are now worth $1300.
With debt-products like bonds or savings accounts, the upside or maximum return is capped at the predetermined interest rate or yield. However there is no theoretical cap on the returns from investing in equity.
You can choose to invest in a high risk biotech company trying to bring a new drug to market or a profitable 80-year old multinational consumer goods company. With the former, you can earn multiples times on your investment if the company’s thesis succeeds whereas with the latter, you could earn a return in percentage points similar to investing in investment grade debt.
Statistically, investing in equities has consistently created higher long-term returns than investing in bonds or savings products.
Risk: Investments in public stocks are also generally higher risk than investing in bonds. The main factors are as follows:
There’s no legal mandate for a company to pay the same dividend yield as it did in the past, unlike bonds where the debt issuer has to pay the coupon rate or interest expenses agreed upon in the debt contract. Thus cash returns will be variable and are contingent on the company’s business performance which in turn is contingent on general macroeconomic conditions, trends in the industry relevant to the company and the company management’s performance.
If a company fails and goes bankrupt, equity holders are last in line to claim any residual value from the company. Debt holders will always be paid before equity holders. Equity holders are always at higher risk if a company becomes insolvent as compared to debt holders.
The value of the capital you invest in a business is highly dependent on market perceptions of the company. Assuming fundamental business stays the same throughout your investment period, your capital returns will also be dependent on market sentiments about the company at the time when you make the investment and the time when you exit from the investment. It often happens that high-performing companies are over-hyped by the market and shares are overpriced during certain periods, whilst being under-priced during other periods.
In shorter-term periods, the company’s market valuation determined by the share price, can deviate significantly from the company’s fundamental value, in either direction. If you buy at a time when the share price is overpriced and sell when it’s under-priced, it can be that you make a loss on your investment even with the underlying business being high-performing and profitable.
Public stocks are high liquidity, almost by definition since they’re listed and actively traded on the stock exchange. You can approach the market at any time via a broker to buy or sell shares in listed companies.
In mature stock markets competitive brokerages and market-makers, for small-medium sized transactions in the stock of actively traded companies, trades can be completed almost instantaneously and with little transaction costs.
There are some companies for which there are often few buyers or sellers and insignificant volume changes hands on a typical day. Trades In these companies can be slightly costlier and can take longer to complete.
During extra-ordinary market events such as a market crash, a natural disaster or a national emergency, stock-markets may suspend trading for certain time periods to prevent market panics. Such events though are rare.
In the next posts, we’ll cover in detail Real Estate, Commodities, Forex, Cryptocurrencies and Private Equity as individual asset classes. After that, we’ll cover how you can invest your savings in these asset classes either directly or via funds that invest pools of money into these assets as per their mandates or strategy. Subscribe and stay tuned for the upcoming posts in these series.
Financial information can be complex and daunting on the onset, but once you get a general sense, many things start becoming simpler. If you would want me to go deep into a particular area that you feel relevant, please mention in the comments below.