The fundamental accounting equation states that the assets of a company must equal the sum of the entity’s liabilities and equity. This means that all assets in the economy are financed either by debt or equity. In the same way, all traditional publicly traded financial assets can be categorized as debt or equity securities—known as bonds and stocks, respectively.
The way these investments potentially generate return (capital gain and/or income) for investors, and their respective risk, determines their attractiveness for the construction of portfolios. The following list gives a feeling of the main differences between the two distinct asset classes. A good rule of thumb: stocks carry more risk than bonds—more aggressive portfolios therefore have a larger allocation in stocks.
Getting past the definitions themselves, it is important to understand a little about the pricing process. What are the underlying forces that determine the movements in the value of stocks and bonds? In strictly theoretical terms, the price of any financial asset is the present value of all future flows, discounted at an interest rate.
This applies to bonds, stocks, or any other kind of financial asset. But the main difference is that bonds have more certain cash flows, and that the time period is well defined. In the case of stocks, a company could live forever, while companies are not required to pay dividends, and dividend payments may be initiated, paused, or ceased at the will of the company.
This implies that changes in price are determined by variations in expected cash flows, discount rates, or both. Both elements are variables that cannot be observed, but which are essential to understand market fluctuations. The following chart is a good way of thinking about this.
The analysis of stocks and bonds has an incredibly large literature, associated to many different schools of thought. However, these are the most fundamental concepts when starting to navigate the financial world, as well as understanding the factors that inform the design and implementation of investment portfolios.
Disclosures
This material is for informational purposes and is intended to be used for educational and illustrative purposes only. It is not designed to cover every aspect of the relevant markets and is not intended to be used as a general guide to investing or as a source of any specific investment recommendation. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. This material does not constitute investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. In preparing this material we have relied upon data supplied to us by third parties. The information has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by Altafid, PBC or its affiliates, as to its accuracy, completeness or correctness. Altafid, PBC or its affiliates do not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regard to the results obtained from its use. Altafid, PBC or its affiliates have no obligations to update any such information.
