What is a stock, and what is a bond? Do you know the differences between them? Most people know that stocks are more risky than bonds, but they don't know why this is the case. It's my hope that through the following lemonade stand illustration, you gain a better understanding about stocks and bonds.
When Life Gives You Lemons
Pretend that you've decided to be an entrepreneur and start your own lemonade stand. Congratulations!
After much research, you've figured that you need $10,000 to get it started (I know you can start one for much less, yet you want to ensure your lemonade stand is better than the kid's down the street, right?). But there's a slight problem: you don't have any money. So what do you do?
You may think you can borrow money from the bank. However, banks usually don't like to lend to startup businesses, so that funding option is probably out.
Since you can't borrow from banks, let's say you find an investor (we'll call him Mr. Bond - no, not THAT Mr. Bond!) who believes in your business and is willing to lend you half of what you need ($5,000) at 5% interest over 5 years (feel free to ignore the numbers for now - just remember that you're getting half of your funding from Mr. Bond). Think of Mr. Bond's investment as a loan to the business.
Another investor (we'll call him Mr. Stock) is willing to give you $5,000 to help you start the business, but he wants a 25% ownership stake. Since you need the capital to start the business, you're willing to give up 25% ownership (equity) for access to the $5,000 in capital (think Shark Tank).
Congrats! You now have the funding you need to start your lemonade stand. Let's quickly review your situation: you now have $10,000 in cash ($5,000 from Mr. Bond and $5,000 from Mr. Stock - which you'll eventually use to operate the business) and own 75% of the lemonade stand. You are still the manager and operator of the lemonade stand. You have two silent investors, Mr. Bond (owns 0% of the business) and Mr. Stock (owns 25% of the business).
Mr. Bond and Mr. Stock
As you may have guessed, Mr. Bond represents the bond investor, and Mr. Stock represents the stock investor (clever, right?) And they both have different risk and return expectations.
Mr. Bond expects that over the course of 5 years he will receive regular interest payments in the amount of $250 ($5,000 * 5% = $250), and at the end of the 5 years, he will receive back his initial investment of $5,000. Therefore, as long as the business doesn't go bankrupt, Mr. Bond will receive a steady annual 5% return on his investment.
On the other hand, Mr. Stock's investment return is completely up in the air. Since he's part owner in the business, Mr. Stock's return depends on how well you're able to manage and grow the lemonade stand. If you truly have a great product and manage the business well, he'll likely see a good return on his investment. However, if your product is mediocre or you're bad at managing the business, he'll likely see a poor return on his investment.
To illustrate this point a bit further, let's pretend you sell the business at the end of 5 years. Here's a simple graph showing both Mr. Bond's and Mr. Stock's return given specific selling prices (from $5,000 to $50,000):
As you can see, the bond investor will get a steady 5% annual return no matter the selling price of the business. However, the stock investor's return depends greatly on the selling price, because again, he's part owner in the lemonade stand. If the business has grown and it sells for $50,000 then the stock investor will likely be very pleased with his investment. However, if the business turns out to be a lemon (sorry…couldn't resist!), he'll likely experience negative investment returns.
Admittedly, the lemonade stand illustration isn't perfect (both bonds and stocks are typically traded on secondary markets, which we'll discuss more in a later post). But I hope it gives you a general idea of how bonds and stocks work, and a better understanding of why stocks are inherently more risky than bonds.
Here's a quick overview of the real-world difference between bond investors and stock investors:
As a bond investor, you're making a loan to a business (or government, agency, municipality, etc.), and expect to get regular interest payments and a return of your initial investment. Above all else, bond investors typically care deeply about the creditworthiness of the entity to which they're lending. They basically want to make sure the entity will be able to pay them back with interest.
On the other hand, as a stock investor, you're taking an ownership interest in the business in the hope that it's managed well and grows over time. Stock investors are typically focused on the underlying business, management team, and sustainable competitive advantage(s). They want to see the business grow at a rate that compensates them for the added risk of being an equity owner.
While the bulk of this post is focused on understanding the difference between stocks and bonds, I'd like to quickly examine one more hypothetical in regards to the lemonade stand.
Let's see what happens if Mr. Stock is an especially savvy investor and he's able to convince you that his $5,000 investment is worth 49% of your lemonade stand (after all, you wouldn't have a lemonade stand without his investment!). Remember in the earlier example, Mr. Stock invested $5,000 for 25% of the business, and now he's wanting 49% of your business for the same investment. In essence, he's buying in at a lower price. Here's the graph to show you how this changes the annual returns:
You'll notice that everything stayed the same (compared to first graph) except the green line: it moved up. By effectively paying a lower price for the lemonade stand, Mr. Stock both increases his potential return and decreases his risk.
Keep an eye out for a later post where we discuss this concept in further detail using Benjamin Graham's parable of Mr. Market.
Does this simple lemonade stand illustration help you understand the difference between stocks and bonds? How does it change the way you think about stocks and bonds?
Ben Malick, CFA