The Financial Sector - Bonds, Stocks and Shares - should you or shouldn't you?

Malaya, Betsy Justin. I'm really excited by today's topic and
I'm hoping I can get some free world class advice
from you both.
Okay, here wrestling nows.
So I have the Financial Times in front of me.
I'm opening the market data pages, so I am seeing
numbers to do with the SMP five hundred where this
is going on. Then a bit further down, let's see
we have we have bond indices, index linked ten year
government spreads, high yield, and emerging markets. I've got tons
of tables in front of me, some graphs, just a
lot going on on this page.
I like the fact that you're getting organized and you're
going to get active with your money. Now. These are
big issues and it's time to get some research done.
Well.
I have to say, this is all pretty confusing, and
I've not actually put my money into anything yet, but
I'm hoping you could. You could help me navigate some
of these graphs and chants and things.
Na I hope you don't have your money under a
mattress right now.
No, she's just the ft. He does not have a
mattress index and big surprised and as I get questions
like this, a lot all economists do, but I'm here
to give you some unexpected advice.
Putting money into stocks and bonds can be a pretty
good way of supercharging your savings, but there are plenty
of pitfalls along the way, which is why it's important
to know a bit more before you move your money
from your savings account to other more complicated financial markets
like the stock market. The financial sector and financial markets
are what we'll be looking at on today's episode of
Think Like an Economist with Me Betsy Stevenson and.
I'm Justin Wolfers. This is the podcast where we teach
you the super tools of econom makes it'll transform your life.
NaSTA Antevichally Farr and her Financial Times are with us.
Nas tell me about your plans.
I've been doing quite a bit of research over the
past few months. Basically, I've got a bit of money
sitting in the bank in a savings account and it's,
you know, earning a little bit of interest. But I
feel like I want to get more back and I
should be able to put my money somewhere better where
it's going to earn me something.
So you've discovered the simplest investment vehicle, which is just
to leave your money in the bank. The problem with that,
of course, is the real return you get how much
more stuff you can buy with that money in the future.
It's really low. It's low risk, but it's low return.
Yeah, a bank savings account just doesn't have very much risk.
In fact, in some countries it has no risk because
of deposit insurance. And it's pretty liquid, which means that
you can walk into your bank today and withdraw all
of your money and your bank should be able to
give it to you. But those two things together, I mean,
you're not going to earn very much to interest when
you put your money into a savings account.
Betsy's just highlighted the two big ideas I want you
to be thinking about. The first is risk, what's the
chance you lose a lot of money? And liquidity? Will
you be able to easily and quickly convert your investments
into cash without losing much along the way.
I'm reading a lot about stocks and bonds. Well, they're
the main things that are coming up and the pros
and cons of each. So bonds are like loans and
stocks are like a percentage of the company.
Yeah, let's start with bonds. Bonds are when we lend
money to companies, or when you lend money to governments
and you get paid back with interest.
Companies and governments need to raise money and one of
the ways they do this is through issuing bonds. Same
Microsoft needs two hundred million for money to spend on
research for upcoming products. They could go to a bank
to borrow two hundred million dollars, or they could start
issuing bonds. You would buy the bond, which is basically
giving the amount you pay for that bond as a
loan to Microsoft. The bond states the conditions of the loan,
meaning it states when you'll get paid back and how
much interest you'll get paid.
So if you're a holder of a bond issued by Microsoft,
then you're a lender to Microsoft. Now this sounds kind
of weird to me because I don't have that much
money and Microsoft is a huge company, so why are
they coming to me for a loan.
That's the magic of the bond market nets you're going
to lend them just a small fraction of what it
is that they need to borrow. Microsoft could try asking
one lender, say a bank, to borrow that full two
hundred million. But say something happens to Microsoft and they
can't pay it back.
Lending two hundred million to one person or company is
basically a big risk for the lender.
Yeah, but what if Microsoft has to borrow a thousand
dollars instead. Well, if something happens and they can't pay
you back, losing a thousand bucks is a much smaller risk.
And so when companies or governments issue bonds, they get
lots of lenders to each lend them smaller chunks of money.
This a layers the lenders to spread their risk and
be more willing to lend in the first place.
So, as I'm going through all these tables and charts
and things, I'm saying that governments also issue bonds. And
we hear about US treasury bills, which are also called
t bills or treasuries. There's guilts in the UK and
buns in Germany.
It's the exact same idea. Just as companies need to
borrow money, so do governments, and governments do it through
the bond market. So whenever you hear about government debt,
remember the government's not borrowing from a bank, it's raising
that money by issuing bonds. Now, there's not much risk
in lending to the US government, but they need lots
of people to be able to borrow trillions of dollars
since no one person could front them, you know, a
multi trillion dollar loone.
In a lot of ways, I like the sound of
getting into bonds because I like this concept of lending
my money to a government so they can spend on
a big public infrastructure project or something really important for society.
But how worried do I need to be that I'm
not going to get my money back.
I wouldn't be that worried lending money to a government.
But the reality is that whenever you lend money, there's
always a risk that you won't get it paid back.
One of the main risks with bonds is what we
call default risk. So when you think about buying a bond,
particularly a corporate bond, you want to try to figure
out how risky it's gonna be. And the way you
can assess that is by using what are called credit ratings.
Those ratings are going to tell you how risky that
bond is in terms of its ability to get paid back.
Yes, so there's ratings companies like Fitch, Standard and Pores Moodies.
They put ratings next to bonds, so I'm looking on
my tables. There's stuff like triple A B C minus,
which sound like sound like grades for a university paper.
Yeah, well it's not that different. I mean, these are
gonna help you decide if you want to lend or not.
Then it's worth remembering that the worst of bonds ratings,
that means that we think they might not pay back.
So the higher the interest rate the bond needs to
offer because they might default.
Okay, so these credit ratings are helpful. But the other
thing I'm worried about is what if something happens, like
I have a big family emergency or something, and I
need my money now. With my money being in a
savings account, I can just go to the bank and
take my money out, But what if it's tied up
in a bond. And also the bonds i'm seeing they
tend to promise to pay me back in like seven, ten,
twenty years time, so quite a long way down the line.
Yeah. So, I mean, you're right that a bond doesn't
have the same liquidity that your savings account has. But
remember last week when I said the stock market is
a second hand market, Well, there's also a second hand
market for bonds. That means you can resell your bond
to someone else and hopefully you'll get a pretty good price.
And what do you mean by hopefully?
Yeah, that doesn't sound that great, right, You're like, Eh,
I would like it to be more like, for sure,
I'll get it for the price. Well, look, it could
be hard to find a buyer, particularly if you're holding
a more niche bond from a small company, or if
the company's credit rating has been downgraded since you purchase
the bond. We call this liquidity risk. Bonds issued by
major governments are just not that risky. Usually they tend
to be plenty of people who want to buy German
bonds or UK guilts or US Treasury bills every single day.
But it can be harder to find a buyer to
a bond issued by a small company.
And so that's the logic for why bonds issued by
these big governments tend to be the most stable places
to keep your money. US government bonds are the safest investment.
Is the US government always pays its debt.
We hope, so look, they can always print more money.
I mean, it would be very unusual for the US
to default on its dead but I do feel like
every time I say that I should knock wood or something.
Yeah, but people seem to believe that. And so there's
a lot of demand for US treasuries and so around
five hundred billion million dollars of them are traded every
single day.
Wow, that is huge. Okay, So one last thing about bonds.
We've talked about risk, But what happens if a company
goes bankrupt If.
A company to close bankruptcy, then all its assets get
sold and they're used to pay off its debts. Now, remember,
if you own a bond, you're one of those debts.
So bondholders get paid before shareholders will come to shares
and shareholders in just a moment.
And what about if a company owes more money than
it can raise by selling off its assets.
Well, then the bondholders will get at least a partial
payout and stockholders will get nothing. That's the risk you
hold if you own part of the company.
Overall, I'd sum up bonds by saying they seem fairly
low risk and relatively stable. You're basically getting your loan
back plus interest, and this is pretty low rewards compared
to what you could get back on the stock market,
which is the other place I've been eyeing. Okay, I
am now looking at stock market biggest movers and maybe shakers.
This section in the FT so in Japan, I see
car companies Toyota, Mitsubishi. US, we've got Apple, Amazon, Microsoft, Facebook, Pfiza.
In the UK, we've got Astrazeneka. It seems like there's
a lot of these COVID vaccine makers in these mover
and shaker lists.
Now, it's actually what I really like about the companies
you just listed, And not all of them, but a
lot of them are companies that actually did pretty well
because of the pandemic. And so one of the reasons
why you're seeing these big movers is because like everybody's
staying home and streaming Disney. We've got Amazon, which just
was you know, obviously pandemic winner. Here, I mean, not
all of them. You know, we're going to talk about
what determines how stock prices change. You know, there's just
like a lot of uncertainty about what's that sort of
fundamental value of the company. So let's dig into stocks
and think about where it comes from.
I like the thought of lending to one of these
vaccine makers right now, Sayffizer or astrazenica.
You absolutely want to invest in a vaccine make a
twelve months before a pandemic.
You gotta be really careful about trying to think that
you have something to add here. So let's back it
up and think about what a stock price is all about, what.
A stock's all about ness. What you're discovering is companies
have a whole lot of different ways of raising money.
They could go to the bank, they could issue a bond,
But the other thing they can do is issue stock
to the public. That's two people like you and matinace.
When they issue stock, when it's brand new stock, that's
raising money for the company.
And if you hold that stock and then go and
sell it on the stock market, that's just reselling second
hand stock.
Yep, that's why I said the stock market it's just
a big second hand market because most of the stocks
you see traded are stocks people already owned. It's not
raising money for the company, it's just stocks changing hands.
So let's say you bought shares Infiser NAZ. You'd be
getting a tiny fraction of the company. If you bought
the right number of shares, maybe you'd own one billionth
of Pfizer.
If you buy shares Infiser, you become a partial owner
of Pfizer. Well, if Pfizer makes money, so to you.
At the end of the year, Pfizer will tally out
its profits. It may decide to pay some portion to you.
These are called dividends.
And it'll take the rest and reinvest it in creating
new vaccines. So some companies pay out dividends really frequently,
say every three months or so. Others pay them much
more infrequently and instead use their profits to grow the company.
But that doesn't cost you money because hopefully that reinvestment
will still generate a return for you, because if the
company becomes more valuable, your shares become more valuable, and
so you'll still get richer. But only when you sell
that stock.
By owning shares of the company do I get other rights.
I'm thinking this because ownership tends to generally give people
certain rights.
You bet, if you buy stock in Pfiser, you own't
part of Pfiser, So you'll get to vote in shareholder meetings,
and often you get to have a say in major
decisions like whether fireser mergers with another company, or really
big strategic questions like that. Not the day to day stuff.
Now, going back to my list of biggest movers in
the Financial Times, there are columns telling me about the
closing price and also the days change in the price.
There are also some charts and graphs which you know,
show movements and price throughout the day. What's all of
this about.
That's the other way you can make a profit from
owning stock. Some people used to invest because what they
are after was dividends. But the other thing that can
happen is the value of your shares rise over time.
So right now, the outlooks pretty good for vaccine makers
like Astrazenic, Real Phizer, and that's why they're on the
biggest Movi's list.
Now, I quite liked the iSER of bonds. I'm thinking,
what are the pros and cons of shares compared to bonds.
Well, with shares, your profit if the company profits. Right,
So that's when we were talking about if you could
go back in time before the pandemic and have bought
those shares the vaccine makers or Amazon, well, those companies
just became a lot more valuable now, and that would
mean that your shares became a lot more valuable, So
you profit when the company profits. If on the other
hand you'd been thinking, you know, what I really want
to do is buy some shares and a hospitality company
prior to the pandemic, Well, you would have been a
loser along with the company, because that's basically it. You're
like a part.
Owner, higher risk, higher return.
And then I'm going to come back to my big
concern again. What if I have an emergency and I
need to get access to my money quickly.
Well, you're going to have to go back to that
secondhand market, the stock market to find someone to buy
your shares. But don't worry, shares tend to have pretty
high liquidity, and I think you'll be able to find
someone to quickly buy your pfisor shares if you urgently
need the cash. The value of those shares, however, is
going to depend on what people currently think the value
of Pfizer is. So if it's gone up or down
since you bought your stock's going to affect whether you
sell it for more or less than what you bought
it for.
Now, Betsy justin, I want to know what to do
with my small stack of money. So we've just done stocks.
I'm interested in these graphs that are showing changes in
stock prices, and I'm guessing these may be determined by
supply and demand.
Now as at this point you're getting it, everything is
determined by supply and demand, including stock prices, And so
you can think of yourself as both a potential buyer
of stocks. You might buy some astrasenica or a seller.
You might think about selling your fires as stock.
But how do I know if the price is right
and if I should be selling my astrosenica stocks.
The truth is you'll never know. But one way of
thinking about it is buying or selling a share all
depends on the comparison between its price and its fundamental value.
The fundamental value of a stock is the present value
of the future profits that the company's going to earn.
Yeah, so this goes to theory that if a company
is doing well or their future looks promising, then their
share price will rise.
Yeah. It sounds complicated, but really you're simply asking yourself
how much you think the company's really worth. That worth
is about its future stream of profits.
So there's really two lenses for thinking about what determines
stock prices. In the first instance, it's determined by supply
and demand. But buyers and sellers. Why are they buying stocks.
It's because they value the stream of future profits. And
so what really matters, what's driving their behavior is the
net present value of the company's future earnings. So it's
all about its future prospects.
You're talking a lot about beliefs about a company and
how well they're doing now and how well we think
they're going to do in the future.
I am. And that's because if there are thousands of
people buying and selling stocks and doing their homework, then
stock prices will come to reflect all of the different
pieces of information that was driving the decision of those
buyers and sellers. So this is the idea we call
the efficient market hypothesis, that company's stock price will come
to reflect all publicly available information.
So this is a really important idea. So let's say
that there's some good news about Visor. You know, some
of the chemicals used to make the vaccine or cheaper,
or turns out the vaccine is more effective than people
originally thought. Well, that means that Visor's future profitability is
likely to be higher. And if it's higher, it means
it's fundamental value is higher, means it's future stream of
profits is higher. That means people want to buy stock
Advisor it's worth more. And so an analyst who discovers
that good news, they want to run out and buys
stock in that company with the good news as soon
as possible.
Yeah, and I see that this will then push the
price up.
Now here's the depressing part. This is why it's hard
to actually make money trying to cherry pick the perfect stock.
It's a lot of work to try to figure out
a company's future value, and there are a lot of
specialists trying to do it.
The reality now is actually tough to beat the market division.
Market hypothesis doesn't mean that a stock's price is always
equal to its fundamental value. I think this is a
place where people get confused. But it means that it's
impossible to predict if a stock is priced accurately based
on publicly available information. And here's the thing. Men love
to actively trade stocks. Oh figure, but they lose money
on average.
All the time. What do you mean by they lose money.
Well, they should have just invested passively, which is when
you buy an indexed fund it's called indexed. It's going
to give you a tiny little bit of each item
in the stock market. Or the index that you're looking at,
say that S and P five hundred.
So you mean that you can only really make money
and assess of a stock is over underpriced if you've
got access to some kind of inside information or something.
Now that's called insider trading, and it's illegal.
The point we're trying to get to is that there
are these thousands of highly paid analysts working in all
sorts of investment houses, and they're all doing homework to
try to predict the future of each of these companies,
and the moment they get a sceric of news, they'll
start trading on that information. As a result, it becomes
impossible to predict if the price of a stock's going
to rise or fall, because if it's going to a
rise next week, someone will go ahead and start buying
it today.
Rights I've already risen, and.
That's the problem. So some wise guys trying to beat
you to predicting where the market's going, and as a result,
you can't see where it's going.
So I've been looking at all these charts and graphs
and trying to find a pattern. Do you mean to
say that that's not really gonna help me?
It's not gonna help you at all. You can't predict
the unpredictable. But the truth is most humans think they can.
Because we're fallible. We like to think that we can
spot patterns, that we can find order among the chaos,
or we can pay the best stock picker to tell
us how. It gives us psychological comfort, But it's dead wrong.
So if I can't spot any patterns with what's going
to happen with Pfizer or Apple's share prices, why would
I pay someone a lot of money to make these
trades for me?
Oh gosh, all the world managers and stockbrokers are gonna
hate us now. But yeah, there's no point in paying
them to move your money around to supposedly get the
best returns. You might as well hire Orlando the cat.
I love this story. A few years ago, as a
British newspaper, The Observer, they ran a stock picking contest
and they recruited a bunch of financial experts, some high
school students, and a cat called Orlando. And so everyone
was given five thousand pounds at the start of the
contest to spend on stocks, and the goal was to
see who could create the most valuable portfolio by the
end of the contest.
There are a lot of these examples out there in
the world, where you know, you sort of show that
people really skilled can't beat the person doing it randomly.
But this's my very favorite example because the random person
was not a person. It was Orlando the cat, who
was picking his stocks by throwing his toy mouse onto
a grid with numbers which represented different companies. So Orlando
and his toy mouse picked stocks, and at the.
End of the year, Orlando's portfolio made five hundred and
forty two pounds in profits and the professional investors made
only one hundred and seventy six pounds.
So I've got a cat for you, nas.
The point here isn't invest through a cat. The point
is even these super fancy guys in super fancy suits
are no smarter than your cat.
Look, you just can't waste your time hiring a stockbroker
to trade for you. The secret is to just put
your money into well diversified index funds. It's what most
economists do with their savings. Is you buy an index
with all the funds and say the S and P
five hundred index, or say the Footsy one hundred index.
You get a well diversified portfolio and you just leave
your money there to grow.
I really like the sound of this.
Actually that's the power of the efficient market type of this.
We learned that we can't predict future stock performance. We
learn to be humble so we keep things simple.
Another tip is to pick a fund with the smallest
fees so that you can keep more of your profits.
That's really really important because there are a lot of
people out there. They're going to charge you a lot
of money to do a lot of trading. They're not
going to make you any money from that trading, and
they're going to safen off a lot of your savings.
You know, this is actually quite a big relief to hear,
because whilst I've been enjoying going through going through the
ft every day and looking at all these jobs and
you know, trying to work out patterns and things, it
also kind of seems pretty stressful. Either I've got to
spend time trying to find patterns and the chals, or
I've got to pay someone to make all these trades
for me, and I don't really fancy either of those.
My advice, nas is think like an economist and don't
bother with all of that this will be the hardest
advice for many of our listeners to take, because there
are thousands of people being paid millions of dollars in
order to convince you that they're smarter than the market.
But the hard reality is when we look at their performance,
they do no better than all Lando the cat.
Betsy justin. That was really helpful. I'm actually going to
put some of my money into index funds, but I
do still want to buy some government bonds too.
You know, bonds aren't quite as sexy as stocks, but
they can be pretty effective if you buy bonds which
mature and take twenty or thirty years time. Remember interest compounds,
so you earn interest on interest and so on, and
the next thing you know, you've doubled your money. Basically,
you're reinvesting what you earn. So you need to start
early and keep reinvesting your gains, and then you'll be
left with a really secure fund for your retirement years.
Albert Einstein is once reported to have said that the
most powerful force on earth is the power of compound interest.
Thanks for listening.
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