Stocks Versus Bonds
In the late seventies a Sicilian mafioso who owned a consignment of heroin, or who answered for it to the people who had put money in, had a choice. Tommaso Buscetta described it to investigators, and Gambetta retells it. He could sell the heroin himself, on the spot, inside Italy. Or he could hand it to a specialist firm to ship it to the United States.
The first way was safer. The second was more profitable—perhaps three times as much, according to Buscetta—but riskier too, because the cargo could be seized on the way. Shipments to America were run by Salvatore Inzerillo until his death in 1981.
I won’t pretend this is ordinary trade. It’s trade in death, and nobody talks about it calmly. But the choice here is laid out so clearly that I don’t know a better illustration. Less, but surer. Or three times as much, but you can lose everything. That’s how everyone with any savings at all chooses. Bonds or stocks?
First in Line and Last
A bond is a debt. You’ve given money to a company or a government, and they’ve promised to pay you a fixed rate of interest and give back the sum on a set date. Whatever happens to the business, you get your interest first. If the company goes bust, you get back what they can manage before the owners do.
A share is a stake in the business. Nobody has promised you anything. You get whatever is left after everyone else: after wages, suppliers, taxes and bondholders. When business is good, a lot is left, and your share grows with no ceiling at all. When it’s bad, nothing is left.
Last in line. But you eat everything that’s left.
We had our own bonds and our own shares too. Gambetta gives an example. Stefano Bontate, head of one of the strongest families in Palermo, gave fifty kilograms of raw material to several refiners, Francesco Marino Mannoia among them, and paid them three million lire a kilo, though on the market that work was worth five. The rest, Bontate explained, he was holding back to share out within the family. The refiners got a fixed fee for their work—their “bond”, and a cut-down one at that. But the whole price of the finished goods, all the risk and all the profit, Bontate kept for himself. He was the “shareholder”.
Who came out ahead? If the shipment reached the buyer, Bontate, and by a long way. If it was seized, the refiners: they had already been paid their three million a kilo, and Bontate lost everything.
Paid for Being Afraid
Why does anyone hold shares at all, if bonds are safer? Because risk gets paid.
Over the long history of the American market, shares have on average brought in about six percentage points a year more than the safest government bonds. That’s what’s called the risk premium. Doesn’t sound like much. Work it out on a napkin. Say bonds pay four per cent a year and shares ten, exactly, every year. After thirty years a dollar in bonds grows to about three and a quarter, a dollar in shares to seventeen and a half. Shares come out almost five and a half times ahead. Only this is a napkin, not a promise. The historical average was worked out over good years and terrible years mixed together, and it doesn’t mean the same increase drips in every year. And we’ve already seen it: gain fifty per cent, lose fifty, and you’re poorer than you were.
In 1985 two economists, Rajnish Mehra and Edward Prescott, showed that this premium is strangely large: by the standard models, if people aren’t too afraid of risk, the difference shouldn’t even reach one per cent. So it’s one of two things. Either people are far more afraid of prices swinging than economists think. Or there’s a risk hiding in shares that the models can’t see. Scholars called it the equity premium puzzle. And they’re still arguing about it.
I think Buscetta partly solved it. Three times the profit—for the chance of losing the cargo. People ask a lot to sleep badly. And they’re right to ask. Whoever holds shares has to be ready to watch half his money disappear for years. Many aren’t ready. They sell at the bottom, when it’s most frightening, and lock in the loss for ever. The premium, if it comes, doesn’t go to the man who bought the shares. It goes to the man who held on.
Safe Bets That Weren’t Safe
There’s the opposite mistake too: taking something risky for something safe.
The fund Long-Term Capital Management, which we’ve talked about already, traded on the difference in price between similar bonds. The bonds themselves were safe, and the difference nearly always closed, so it sounded like bond income: calm, predictable, dull. But the fund borrowed twenty-five times its own capital to make money on a tiny difference. Safe income multiplied by twenty-five isn’t a bond any more. It’s a share, and a very risky one. In 1998 it showed it.
Don’t look at what an investment is called. Look at what happens to you on the worst day. A bond from a company that could go bust is closer to a share than it seems. A share in a huge, stable company that has paid dividends for a hundred years is closer to a bond. What’s written on the paper isn’t the risk.
Fixed Pay or a Share
Remember Morano, who paid Morello twenty-five dollars a week for the lottery? Morello held a bond: he got a fixed coupon and stood first in line. Morano held a share: he took everything on top and carried the risk in the bad weeks. And when the shareholder had nothing left, he decided to cut off the payments along with the man who was receiving them. In the crudest way.
A coupon that rests on force is worth as much as the force.
The Don’s Advice on Wages
When I was starting out with Don Vincenzo, he once offered me a choice. A fixed wage—or a small one, plus a share in the profits from the oil. I was twenty-six years old. I chose the fixed wage: I was afraid of being left with no money in a bad year.
The Don shook his head. “You’re choosing like an old man,” he said. “An old man needs something fixed, he has no time to wait for the good years. You’ve got forty years ahead of you. In forty years the bad years will end, and the share will still be there.” I listened to him and took the share. Ten years later it was bringing me more than any wage. And when I got old, the Don himself suggested turning part of the share into a fixed sum. “Now,” he said, “you can afford to be a coward.”
The Bottom Line
Historically, risk in shares has been paid extra, but not every year and not to everyone: the premium went to the man who lived through the bad years and didn’t sell at the bottom. And don’t trust the name. A debt with heavy leverage is already a share.