You take plenty of risk with your investments. Don't you deserve to get rewarded with better returns?
If your answer is yes -- and I suspect it is -- then you should be invested in stocks. Historically, stocks have outperformed other investments, such as fixed-income securities and cash accounts, by a wide margin. But why does it seem like the best returns are reserved for shareholders? The answer lies in the way companies structure their finances.
Debt vs. equity
Typically, companies raise capital in two ways. They can issue debt, either by borrowing directly from a bank or other lending institution or by offering bonds to the general public through an underwriter. Alternatively, they can sell equity interests to investors, either through selling shares of stock or by offering options or warrants to investors allowing them to purchase shares at a later time. Although some companies, such as Apple (Nasdaq: AAPL), don't have any long-term debt, most companies use both methods to raise capital.
On the risk-reward scale, buying the debt is safer for investors -- although perhaps not as safe as you think. Debtholders are entitled to receive interest on their investment, and if something goes wrong, they have the first claim against the company's assets. When a company files for bankruptcy, debtholders often get a significant portion of their investment back, either in cash or in shares of the post-bankruptcy company.
In contrast, shareholders have relatively few rights. Companies don't have to pay them dividends. If anything goes wrong, they have to get in line behind debtholders, and so they often get nothing in a bankruptcy.
Stocks: Where the rewards are
In exchange for taking on that added risk, however, shareholders get potentially limitless rewards. Bondholders know up front how much their maximum return will be -- it's the interest rate the bonds pay. If a company grows more quickly than that, then all the excess goes to the shareholders.
To see how this works in real life, let's take a look at a few companies that issued five-year bonds back in 2003:
|
Company |
Coupon Rate on Bonds |
5-Year Average Annualized Return on Stock |
Advantage for Stock on $10,000 Investment |
|---|---|---|---|
|
Hewlett-Packard (NYSE: HPQ) |
3.625% |
25.6% |
$19,289 |
|
Praxair (NYSE: PX) |
2.75% |
27.5% |
$21,608 |
|
Avnet (NYSE: AVT) |
9.75% |
26.2% |
$16,049 |
As you can see, shareholders got much more of the benefits from strong growth from these companies over the past five years. Avnet grew earnings at a 60% clip, HP at more than 27%, and Praxair at almost 20%. Yet bondholders only reaped a fraction of that growth, leaving the rest for shareholders willing to take on more risk.
Of course, things don't always go shareholders' way. For instance, with bankruptcies in the airline sector, shareholders have traditionally been wiped out. The shares of United Airlines parent UAL Corp. (Nasdaq: UAUA), Northwest Airlines (NYSE: NWA), and Delta Air Lines (NYSE: DAL) were mostly given to bondholders at the conclusion of their respective bankruptcy proceedings. Yet even bondholders carry risk in bankruptcy -- many took losses of around 85% in Delta's bankruptcy.
Growth for the long haul
You choose a company to invest in because you expect that company to grow. If you pick the right companies, their stocks will usually perform far better than their bonds do. To earn the largest returns, therefore, it pays to stick with stocks. In the long run, it'll make a huge difference in the value of your investment portfolio.
For more tips on why you can't ignore stocks as an investment, read about:
- The real reason why some stocks are getting hammered;
- Stocks to help you reduce your risk; and
- Why you should shoot for 50% returns.
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Fool contributor Dan Caplinger sticks with stocks for the majority of his portfolio, but he doesn't own shares of the particular companies mentioned in this article. The Fool's disclosure policy is pretty valuable on a risk vs. reward basis.
