The following is an excerpt from the book The Sound Mind Investing Handbook - A Step-By-Step Guide To Managing Your Money From A Biblical Perspective 5th Ed. I've had to modify it a bit since the chart it used to refer to wasn't showing up in the post.
Investing is actually quite simple . . .
. . . because you only have two basic choices: investments where you become a lender to someone and investments where you become an owner of something.
Investments where you lend your money are generally the lower-risk kind. Assuming you do a good job of checking out the financial strength of the borrower, the primary risk is that you might get locked in to a poor rate of return for many years.
Investments where you own something are generally the higher-risk kind. The primary risk here is that the value of what you own could fall, so the economic outlook and its effect on your holdings is of great importance.
What I’m about to tell you is very important, so please pay close attention: The way in which . . .
. . . you divide your investment capital between these two basic choices of “loaning” or “owning” has a greater impact on your eventual investment returns than any other single factor.
Think of your investments as being like a garden. Some people like to grow flowers and others prefer to grow vegetables. Some enjoy doing both. The one decision that has the greatest influence over what your garden looks like and the kind of harvest you’ll ultimately have is this: How much of your garden should you devote to flowers and how much to vegetables? Once you decide that, you know a lot about what to expect in terms of the risks involved and the potential results even if you haven’t yet decided which kinds of flowers or vegetables you’re going to plant. Once you decided how you were going to allocate your space, the kind of harvest you were going to have was, to a great extent, already predetermined.
Now, let me shift your thinking to the investment arena. Studies have shown that 80% or more of your investment return is determined by how much of your portfolio is invested in stocks (flowers) versus bonds (vegetables), and only about 20% is determined by how good a job you did at making the individual selections. This surprises most people, because the investment industry gives far more attention to telling you about hot stocks and mutual fund performance rankings than to explaining the critical importance of asset allocation (that is, how much space you make in your investment garden for stocks versus how much room you allocate to bonds). We’ll look at this in great detail in chapter 16 where I’ll teach you a very simple strategy which puts your focus on “how much you put where” rather than “which ones.”
For now, I just want you to recognize that the economic forces that influence the two basic choices are different. It’s possible for you to invest-by-lending your money to a financially strong company like General Motors in return for one of its bonds and, even in the midst of a deep recession, earn a nice return. On the other hand, it’s also probable that if you chose to invest-by-owning stock of the same corporation and thereby become one of its part owners, the same recession would have caused serious harm—hopefully temporary—to the company’s earnings and dividend payments. As a part owner of the business, you would have likely watched your investment in the company lose value even while its creditors (like the investors who bought GM’s bonds) were happily collecting their interest payments.
Of course, that’s just looking at the risk part of the equation. The other side of that coin is that the owners of a company can enjoy great prosperity during those times in the business cycle when the economy is healthy and growing. The creditors, meanwhile, continue receiving only the interest payments to which they are due.
Consider the five-year period from 1987 to 1991. Investors who allocated 100% of their capital to being owners (by investing in the shares of stocks in those blue-chip companies that are part of the Standard & Poor’s 500 Stock Index) would have received a total return of 15.4% per year during that time. This is despite the fact that the crash of 1987 occurred early in the period. Furthermore, with a few exceptions (notably during the bear markets of 1973-74 and 2001-02), stockholders who hold for at least a five-year period typically do far better than bondholders during the same period.
Investors who decided to allocate 100% of their money to becoming lenders would have earned 10.4% per year during the 1987–1991 period. (This assumes their returns were similar to the bonds included in the Salomon Brothers Long-Term High-Grade Corporate Bond Index, which is an average of more than 1,000 publicly issued corporate debt securities.) They would have made less money and taken less risk. Investors who don’t want to cast their lot entirely with either camp, but choose to split their capital equally between the two basic choices—50% in stocks and 50% in bonds -- have consistently been profitable.
All investing eventually finds its way into the American economy. It provides the essential money needed for businesses to be formed and grow—for engineering, manufacturing, construction, and a million and one other services to be offered and jobs to be created. You can either be a part owner in all this, tying yourself to the fortunes of American business and sharing in the certain risks and possible rewards that being an owner involves. Or, you can play the role of lender, giving your money to others in order to let them take the risks and knowing you are settling for a lesser, but more secure, return on your money.
How to divide your funds between these two kinds of endeavors is your first and most important investing decision. Everything else is fine-tuning.
You have a repeated paragraph in there.
Posted by: Rzrshrp | March 26, 2009 at 10:40 AM
Also, I understand that you may have no choice because the source is a book, but without the graphics that the excerpt is referring to, some of the content isn't helpful at all.
Posted by: Rzrshrp | March 26, 2009 at 10:44 AM
Ugh. Typepad is killing me. I'll try to fix/adjust as possible...
Posted by: FMF | March 26, 2009 at 10:46 AM
Odd that this book (revised November 2008) refers to General Motors as "financially strong". Wasn't that about the time they were telling the world that without a government bail-out they would be bankrupt by the end of the year?
Posted by: cmadler | March 26, 2009 at 11:09 AM
cmadler --
I'm betting there's a HUGE time difference (maybe a year or so) between when a book is written and when it is published. This may be the issue here.
Then again, has GM been strong anytime in the past few years?
Posted by: FMF | March 26, 2009 at 11:44 AM