Your Wealth Journey Investment Insights – How Does the Market Work?

You already know investing is an important part of your financial journey. But, for the uninitiated, a question always crops up.

How does the market work?

Admittedly, it can be a bit confusing at first. But, understanding how to build your diversified portfolio to effectively and efficiently capture those returns is essential. And first, you need to know where all those returns come from.

THE BUSINESS OF INVESTING

In the financial news, it’s all about which stock is up or down and when will interest rates rise or fall and which company is going public or going under.

There is, among the shouts and fireworks of everyday news, a key concept often overlooked.

Market returns are compensation for providing the financial capital that feeds the enterprise.

When you buy a stock or a bond, your capital is ultimately put to hard work by businesses or agencies who expect to succeed at whatever it is they are doing, whether it’s growing oranges, running a hospital or selling virtual cloud storage.

You’re helping to fund a business by owning a small piece of it. You, of course, are not merely giving your money away. You mean to receive your capital back, and then some.

That’s your return, of course.

Even if business is booming, you cannot necessarily expect to reap the rewards simply by buying stock in that same, booming company.

INVESTOR RETURNS VS. COMPANY PROFITS

A company hopes to generate profits. A government agency hopes to complete its work with budget to spare. Investors hope to earn generous returns.

It stands to reason that, when a company or agency succeeds, its investors should too. It’s not always the case.

A company’s or agency’s success is only one factor, at best, among many others that influence its investors’ expected returns.

This may sound entirely loony, but it is definitely the case.

Even if business is booming, you cannot necessarily expect to reap the rewards simply by buying stock in that same, booming company. If you’ve been reading our blog, you know that by the time good or bad news is apparent, it’s already reflected in higher-priced shares, with less room for future growth.

IF IT’S NOT PROFITS, WHAT IS IT?

There are a number of factors that drive returns. We may have said that before, but it’s important to remember.

It’s much more than company profit.

Some of the most powerful influences spring from those unavoidable market risks. As an investor, you can expect to be rewarded for accepting the market risks that remain after you have diversified away the avoidable, concentrated ones.

Consider two of the broadest market factors: stocks (equities) and bonds (fixed income). Most investors start by deciding what percentage of their portfolio to allocate to each. Regardless of the split, you are still expecting to be compensated for all of the capital you have put to work in the market.

But, why does the allocation matter?

When you buy a bond …

• You are lending money to a business or government agency, with no ownership stake (You’re not buying a portion of the Department of Treasury, even if that’s what you wanted).
• Your returns come from interest paid on your loan (Congratulations! You’re a bank. Almost).
• If a business or agency defaults on its bond, you are closer to the front of the line of creditors to be repaid with any remaining capital.

When you buy a stock …

• You become a co-owner in the business, with voting rights at shareholder meetings (Just don’t expect to get your name on the masthead).
• Your returns come from increased share prices and/or dividends.
• If a company goes bankrupt, you are closer to the end of the line of creditors to be repaid (Because the captain goes down with the ship. Kind of).

In short, stock owners face higher odds that they may not receive an expected return, or may even lose their investment.

There are, as always, exceptions.

A junk bond in a dicey venture may well be riskier than a blue-chip stock in a stable company. Overall, stocks are generally considered riskier than bonds and have generally delivered higher returns than bonds over time.

This outperformance of stocks is called the equity premium. The precise amount of the premium and how long it takes to be realized is far from a sure bet.

That’s where the risk comes in.

When looking at stock-versus-bond performance in a line chart over time, you it’s easy to see the benefits and drawbacks of each. Stock returns have handily outpaced bonds over the long-run. Bonds, meanwhile, have offered a much less volatile, smoother ride.

Higher risks AND higher returns show up in the results.

THE WHOLE PICTURE

When all is said and done, exposure to market risk has long been among the most important factors contributing to premium returns. However, ongoing academic research is showing that there may be additional factors contributing to premium returns, some driven by behaviors outside of the risk tolerance scope.

While it may seem reasonable that companies that churn out profits are good investments, there are more factors to consider. An investment professional can help you consider those factors when making your financial decisions.

Keep Reading

• The Introduction to this Series: Becoming a Better Investor
• Start Your Retirement Journey Series
• Find Your Financial Focus

Disclosures:
Securities offered through WFG Investments. Member of FINRA and SIPC. Investment advisory services offered through WFG Advisors, LP. Asset Allocation: Asset allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses. Bonds are subject to market and credit risk of the company as well as interest rate risk and may be worth less than the principal amount is sold prior to maturity. Bonds may be subject to AMT, state or local income tax depending on residence. Please consult with your tax advisor. Discount bonds may be subject to capital gains tax. Prices and availability may change at any time without notice. Insured bonds do not cover potential market loss and are subject to the claims paying ability of the insurance company.