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What are the Differences Between Stocks, Bonds and Alternative Investments?

Today we are looking into Investing 101, and I will be speaking with Scott Poore. He is the chief investment officer for the Eudaimonia Group. The thought for the day is that you have heard a lot of these concepts and terms. There is more jargon in the financial industry than doctors’ experience in the medical industry.

We’re going to be breaking down three basic terms, equities, fixed income, and alternative investments. Throughout this podcast think about these terms and do your best to listen and understand what is being said. The action is to go forward and utilize this information to make decisions on whether it’s your 401 allocations or your investment allocation.

Today will be about Investing 101, there is also Investing 102 and other classes afterward to talk about these terms in more depth and then talk about applications as well. Ultimately, the thought is just to get it, and then the action is to use it in its raw form, but also know we’ll have other strategies in the future as well.

 

Scott’s Role in Eudaimonia 

Scott Poore is the Chief Investment Officer for Eudaimonia Group. He helps clients and advisers figure out how they should allocate and invest their money. More specifically, he matches their risk tolerance and time horizon profiles. A lot of his job is involved in picking securities that go into portfolios and then selecting how that portfolio should be allocated. Scott is proud to say he has been involved in this work now for more than 25 years.

 

The Inside Scoop on Stocks 

If you’re someone that has done very little investing or has never done any investing, the word stocks may seem strange. In Eudaimonia’s language, the words stock and equity are used interchangeably. Moreover, stocks essentially are ways for companies to issue shares to the public to be purchased. This will ultimately provide capitalization to the company. In simple terms, the company may issue 100 shares of their stock and as investors buy that stock, the stock price goes up because that stock becomes more in demand. And that allows the company to use that equity to keep the company running, whether that’s adding new buildings or purchasing things for the company.

Then within that framework of stocks, there are different types. Starting with large caps, which are companies that typically are greater than five or six billion in terms of their market capitalization. For example, in the technology space, IBM is a large-cap company and in the consumer space, Home Depot is a large-cap company. Those companies that have been around awhile are seasoned and have a much larger market value than other companies.

 

Blue Chip Companies 

Blue-chip companies are looked at in terms of growth and value. That said, blue chips could be some of both your large-cap value companies. For example, Exxon is an energy space and that company pays a dividend. It’s a strong dividend that the investor can earn if they own the stock. Generally speaking, that stock tends to be undervalued relative to the rest of the market.

In addition, Google and Apple have a very high market cap. Apple just crossed over $3 trillion in terms of market cap. On top of that, there are growth companies that are more momentum. They don’t produce much in dividends, and they tend to be more overvalued. Most of those are in the technology space. As an overview of what was just explained, Exxon and Apple, You’ve got a technology company and an energy company. One is growth, one is value.

 

Mid Caps in Depth 

Mid-caps are generally in the 2 to 7 billion range. They are unique because more than likely they were once small caps, but they’ve grown in value to that mid-cap space. And if the company has run well, at some point, it’ll become a large-cap company if the company continues to do well.

For instance, Regents Regions Bank is a regional bank in the Southeast. That company is a mid-cap. It’s not a big bank and it’s not a tiny bank either.

 

Small Caps Explained 

The small-cap is weird because it could be a small-cap company or it could be a microcap. Both of those tend to fall under a billion in market cap. Those companies are typically more volatile because there are fewer of them and they’re kind of in that still startup phase, not necessarily the first three years, but the first ten years of development, they tend to be riskier.

That said, you could buy a small-cap company that goes bankrupt. There’s a lot more inherent risk there. However, with that risk comes a lot more return. With a large-cap company, you think about a seasoned company like Home Depot that does the same type of revenue year in, year out, except for a recession. It’s still in the beginning stages of development. They could take a risk on a product or service, and it doesn’t pan out so they fall in value. On the other hand, if they do well, picking the right product, right service to offer, they could explode.

Someone like Lululemon several years ago would have been a small-cap because it was brand new. It was a new type of clothing line and there was a lot of uncertainty. It became extremely popular, they’ve taken off, and now they’re a mid or large-cap stock, depending on what day you look at them.

 

All About Bonds 

Instead of a company issuing shares to get capital, in this case, what a company will do is they will issue debt. For instance, they issue one bond and that bond has a total amount of a million dollars. They will take that million dollars as people buy the bonds. People buy bonds. The investor is giving the money to the company so that the company can use it today, and the company is going to pay that investor an interest rate, typically every month for the rights to have that money. If you’re an individual investor and you buy a bond worth $10,000, you’re giving the company $10,000. Today, they are issuing you shares of that bond, and they’re going to pay you an interest rate depending on how much of that bond you purchase. Let’s say you bought $10,000, they’re going to issue you a 1% interest rate, which would be pretty low, but they’re going to issue you 1%. And so you’re going to get $100 a month in terms of interest to you as the purchaser of that bond.

 

Stocks vs. Bonds 

The difference between the stock and the bond is that the bond has a stated maturity. Consequently, that bond may last for ten years. It’s a ten-year bond of $10,000. They’re going to pay you monthly interest for ten years, and then that bond matures. And when it matures, you now have no more interest in the company, unlike a stock that you could choose to own in perpetuity. That’s the main difference between stocks and bonds. Bonds typically are labeled as debt because again, the company is issuing debt. They’re taking your money today and they’re paying you interest. They owe you that interest. If that bond fails to pay the interest to you as the investor, that is going into default. And that’s where a bond can get extremely risky. So that kind of gets us into different levels of bonds.

If you think about the federal government, they issue bonds in different maturity ranges, the most secure being three-month T-bills, which is three months of maturity, very safe, versus a 30-year bond, which has a lot more risk with it. And so those are government bonds. Now, government bonds tend to be a little bit higher in terms of quality because if the government fails, we all fail versus a corporate bond. In summary, a corporate bond is on a different level and could carry a higher level of risk.

 

Maturity Risk 

If you think about a chart on the end of the chart near the corner, those are your shorter maturity bonds. You buy the bond, let’s say a T-bill, you purchase it today, three months from now, it matures, and that holding goes away. That’s on the far left-hand side of the curve, as the curve goes up, your maturity levels go out. And so if I’m going to buy a 30-year bond, that means I’m not going to get my money back until 30 years from now. There’s a lot more risk there because a lot more things can happen in 30 years. We can go through three different recessions. The government can go through multiple phases of fiscal spending or cutting fiscal spending. Ultimately, there’s a lot more risk with a 30-year bond before you get your money back versus a three-month T bill. And so that’s maturity risk.

 

Credit Risk 

Then you’ve got credit risk. A government bond is going to have a much lower level of risk because it’s a higher-quality bond. The chances of the government paying you back over the next three months or 30 years is a lot higher than a company paying you back because a company can go through a lot of different risks, go through bankruptcy. If the government goes into bankruptcy again, we’re all in trouble. In terms of credit risk, you’ve got much higher-rated government bonds than you do corporate bonds.

Now, within the corporate space, though, you may have a company like a Home Depot. We talked about that very consistently. Typically year in and year out, they do well. So the credit rating on that bond is probably going to be higher than a credit rating on a small-cap company. Again, if we kind of use the Lululemon example when they were first getting started and if they had issued debt, well, we weren’t sure what was going to happen with their clothing line, was it going to take off or not? So there’s more risk there. That credit rating would be much lower, or it could even be what they call junk bonds. Anything below triple B rated is considered a high yield bond or a junk bond because you’re taking a lot more risk there. If it’s a ten-year bond, you’re going to get your money back in ten years, maybe not. So it has a lower credit rating.

Now, again, in that space, if the company does well as Lululemon did, you might do exceptionally well. Therefore, that bond is not only paying you higher dividends or higher interest rates, it may appreciate over time if the company does well. There is a lot more risk on the lower end of the credit quality space.

 

Alternative Space Defined 

The alternative space is very wide open. Unlike a true stock or a true bond, that definition is a pretty straight path. Alternatives can incorporate a whole different host of different types of securities. The key with alternatives is it has a much lower correlation to stocks or bonds. Correlation is when a stock is appreciating and the equity market is doing extremely well, an alternative investment could be doing well, or it could be not doing as well, depending on what the function of the alternative investment is.

But the key is it adds an extra layer of diversification. Instead of just owning stocks and bonds, you can also own a few alternatives. Now, the alternative is a wide-open definition. Some of us consider real estate, for example, a form of alternative investment. It’s not equities and it’s not bonds, it’s real estate. You’re purchasing either land or you’re purchasing buildings and incorporated in there is a different type of structure. It’s a little bit similar to debt in the sense that there’s a mortgage perhaps on that investment. And so that’s going to pay a specific amount and it is considered a debt, but you’re also getting the land or the building on top of that.

 

Similarities in Alternative Space 

It’s also an asset similar to equity. It’s a little bit of both, or you’ve got other types of investments that will do something opposite of equities. If you’re an equity investor, you’re purchasing the stock. An alternative investment might short the stock. Instead of buying shares in that stock, they want to go negative on that stock. They think the stock is not going to do well.

Again, let’s go back to our Lululemon example. If somebody thought at the beginning that Lululemon was not going to do well, instead of purchasing the stock thinking it might do well, they might short the stock in the alternative investment market by either buying futures or selling features on the stock or buying a put an option on the stock that would go higher if the stock goes lower. It’s a way to hedge, so to speak. You could do both. You could purchase the limited stock, but if you think it’s going to go through a rough patch for the next twelve months, you can also buy a put on it so that my losses are limited. If the stock goes down, you do well on the put. If the stock goes up, you do well on the shares that I purchased.

There are all sorts of alternative baskets, but typically what they are doing is different from what you’re doing inside of equities or stocks. You’ve got hedge funds that will hedge markets. You’ve got managed features, products that simply will use commodities typically as their instrument. And then you’ve got commodities themselves which are not like equities, so to speak, commodities. You can purchase futures on the corn market or futures on the cotton market. And those are a little bit different than just equities or fixed income. But if you take all three baskets that we’ve talked about, equities, debt or bonds, and alternatives, you build yourself a nice portfolio with a true asset allocation that when something’s not doing well, something else will be doing well.

 

The Ultimate Goal 

In 2008, we had a huge financial crisis and the markets were down, from peak to trough. The US equities were down about 50%. If you own equities in that time frame again, you lost about 50%. If you own bonds, you did okay because bonds held up relatively well. Now, that depends on which bonds.

But let’s just assume that you had typical government bonds. You made a little bit of money, and you also got some interest payments on that. That said, you probably broke about even there. And so equity is down 50%, bonds up, say, 4%, give or take, Depending on which bond you own. Then your alternatives could have done well or not have done well, depending on which alternatives you own. But if you were short the market, if your equities were down 50 and you were short in the market. Then your alternatives were up roughly 50. What that does is that gives you nice asset allocation and reduces your risk. For example, you have 100% equity.

In 2008, you lost 50%. If you had 100% in bonds, you didn’t lose anything, but you only made about 4%. If you had alternatives, you could have made 50% or more, depending on which type of alternatives you own. If you had just equities, you lost 50%. If you owned all three, you probably made some money during that time frame. So that diversification and that asset allocation protected you versus owning 100% of equity.

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