Forget Bonds. Stocks Provide Growth and Income

What’s better, stocks or bonds? Well it depends.

If we were looking to for capital appreciation, then stocks are better. But if you wanted to create a steady reliable income, bonds are better.

That’s the common thought anyway.

But according to legendary fund manager, Peter Lynch, whether you want capital growth or income, stocks are the only answer.

I’ll explain why later. For the moment let’s consider our current situation.

Will Bonds Become Attractive if Yields Rise?

First let’s go back to basics.

A bond is a fixed income security that provides income via coupon payments. Let’s say you wanted to buy a 10-year US government bond. Assume the par value is $1,000 and the bond pays an annual coupon rate of 5%.

That means you’ll receive $50 each year for 10-years. If you hold the bond until maturity then you’ll also receive the principle of the bond – $1,000.

Easy to understand right?

But as you may know, bonds rarely sell for par value. Speculators, traders and central bankers cause havoc within the bond market. It can be annoying sometimes as bonds will trade above par value. But the opposite can also happen. Bonds can trade below par because of too many sellers in the market.

This is what’s about to happen If the Fed continues on their path to increase interest rates. To do so they’ll need to sell bonds to increase treasury yields.

Back to our example…imagine today is your lucky day. The Fed continues to sell bonds and you find the same bond with a coupon rate of 5% trading for $950.

Buy buying the bond at $950, you’ll still receive $50 in coupon payments each year and $1,000 at maturity. But because you bought below par value, the yield on your investment has increased.

Before you’re bond purchase only yielded 5% (50/1,000). Buying at $950, your investment yield climbed to around 5.3% (50/950). Not bad hey.

But this is the problem. You will likely need to hold onto maturity. Because the Fed is determined to lift rates, they will continue to sell bonds down, putting you at a loss if you sell out.

This is why Lynch recommends growth and income investors to focus exclusively on stocks.

Growth vs Income? Why not both

In his book, ‘Beating the Street’, Lynch tells readers:

“Whenever I am confronted with doubts and despair about the current Big Picture, I try to concentrate on the Even Bigger Picture. The Even Bigger Picture is the one that’s worth knowing about, if you expect to be able to keep the faith in stocks.

“The even Bigger Picture tells us that over the last 70 years, stocks have provided their owners with gains of 11 percent a year, on average, whereas Treasury bills, bonds and CDs have returned less than half that amount.”

Lynch then poses three cases to show why a portfolio of 100% stocks is not only great for capital appreciation but can be a great source of income.

 

But if you’re unsure of what to look for, check out my previous post,  ‘The Only Two Investments You’ll Ever Need‘. It will give you a good idea of what to look for and how to avoid pitfalls.

Financial Modelling: Assumptions Built on Assumptions

Wouldn’t it be great to know the future? Sure it might take the spontaneity out of life. But you could become the best investor ever.

There is no such thing as a perfect investment record. Everyone picks up some losers along the way. But if you had an idea of what might happen, you could avoid the ‘bad eggs’ as they say.

This is what financial models try to do. They predict what might happen in the future. Not just profits, but revenues, debt, cash flows and a bunch of other business fundamentals. Judging by the calibre of investors that use financial models, from investment bankers to private equity firms, you’d think they’re the best way to value businesses.

And maybe they are…for the short-term. But I’d argue financial models are a lot less useful than most investors believe.

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