We can anticipate, with great confidence, that stocks will outperform bonds over time. Or, to use more exacting language, a properly diversified portfolio of stocks will outperform bond investments over long investment periods. As an empirical matter, this is borne out by history and can be checked by doing a little research. There is also a purely theoretical underpinning to this belief, though, and it is worth considering. The concept underlying this basic truth may prove to be extremely useful to those whose future material comfort is on the line.
First, let’s get clear on the difference between a stock and a bond. A share of stock is a piece of ownership in a company. As a result, it represents a claim on the future earnings of the firm in question. A bond, on the other hand, is a claim to the interest and return of principal resulting from a debt. To put it more plainly, stock signifies ownership in an entity while a bond represents a loan to it.
Now let’s consider the difference between partial ownership in a firm and lending it money. To do this, imagine yourself a member of the company’s board of directors. The business is considering floating a bond (borrowing money) and is pondering the wisdom of it. The board asks the company’s top officers how much the money will cost. Let’s suppose the answer is that a 20 year loan (bond) will cost 5% per year. Next the board wants to know in what ways this money will be used. Management offers a detailed explanation of how it will deploy the funds. Then the board members ask how much profit can be expected from the proposed endeavor. The answer, of course, must be more than 5% per year.
A company will not seek to borrow money unless it believes a return greater than the cost of that money can be achieved. Thus, a company seeking to float a bond must think it will make more than the interest it will have to pay out. If their best estimate suggests it might be difficult to make back as much as the cost of the funds, they will almost surely decide against taking on the debt.
There is, of course, always the risk that the company’s managers will guess wrong. That happens sometimes; individual firms miscalculate and borrow money they should not have. In the aggregate, though, businesses tend to assess the problem correctly and borrow money when they are able to make more than the cost of the debt. When conditions are not right, they usually refrain from borrowing. On the whole, corporate borrowing is a profitable enterprise and positive returns are extracted from what is sometimes referred to as leverage.
So, as a conceptual matter, companies use debt when they are positioned to make more from the money than it cost them to borrow it. That surplus belongs to the owners of the firm; in the case of public companies it is captured – even if indirectly- by the shareholders. In light of this analysis, would you rather lend money to a company or use that money to buy an ownership interest?