DO you know the difference between a stock and a bond?

TEXT/GRAPHICS: LARRY HAVERKAMP AND MAROO

It is this: a stock means you own part of the company. A bond means you loaned it money.

Stocks and bonds are also called 'equity' and 'debt'. All investments fall into these two categories.

Both are ways for firms to get money to pay their bills or buy more assets for expansion.

A typical debt-equity split is 50/50. It means the business is financed half with debt and half with equity.

Companies get debt by borrowing, usually from banks. The equity comes from owners as well as past income that was never paid out as dividends.

It accumulates and is called 'retained earnings'.

That brings me to a new buzzword from this recession: De-leveraging. It means everyone wants fewer risks and it changes the world's debt to equity split from 50/50 to something less, like, 33/67.

Then, assets are financed one-third from debt and two-thirds from equity.

Take 2006. A company may have had $200 million in assets, financed by $100m in debt and $100m in equity.

Now, in 2009, it still has $100m in equity, but debt would have fallen to $50m. It means only $150m in assets can be financed, and leaves the company no choice but to operate on a smaller scale than before.

De-leveraging hits households too. Banks now require that you put down more of your own money to buy a car or a home.

This is the 'new normal' and is likely to be with us for a long time.

Is it good or bad? Well, on the plus side, fewer risks mean not as many ups and downs in the economy. We will have fewer big recessions.

As explained, however, less debt means fewer assets to work with. The world will operate on a smaller scale. It will need fewer factories, office buildings and workers too.

It means lower growth and higher unemployment. Incomes will grow more slowly. Prepare to tighten your belt.

A company with more equity (ownership) and less debt (borrowing) is safer.

For an investor, it's the opposite: You take big risks when you own shares of a company (equity), and the safer investment is bonds (debt).

Which should you go for, high risk or low?

Most people say: Low risk. Why take chances?

The trouble with that is you also get lower returns.

Ok, let's try for high returns instead. Sorry. Then you have the problem of big risks. Hey, you can't win!

It is true. The pluses and minuses are exactly offsetting. As risks increases, so do returns.

Neither choice is better. Both are equal and fair. The choice depends on your risk preference. It is a personal decision.

Women, for example, often prefer safer investments while men take more risks.

Retirees usually go for safety while young people don't mind taking risks.

Here is a good rule of thumb: The per cent of safe investments should equal your age.

It means at age 50, you would divide your money equally between bonds and stocks. At age 90, you would have 90 per cent in safe assets like bonds and fixed deposits.

A word of caution. Most people think higher risks mean higher returns. It's not always true.

Take gambling. The risks are very high but returns are low. In fact, they are negative. You are sure to lose in the long run.

It is also true for investments in contracts called 'derivatives'. Examples are options, futures, warrants, swaps and forward contracts.

(i) They expire after a few months and (ii) all gains and losses are offsetting, making them zero-sum before commissions. These two features make them more similar to gambling than investing.

Worse still, derivatives often come with high leverage. It magnifies the risks by 10 to 20 times while the average returns remain negative.

It isn't all bad. Derivatives can also reduce risks through 'hedging'. This is done by big companies and banks.

Most people use derivatives for 'speculation'.  Back to Columnists