THE THEORY OF INTEREST

investors, and the positions, in which they stand as tothe effect of their investment on the time shape of theirincome, are really very similar. But the stockholder has arisk attached to his income stream from which the bond-holder seeks to be free. It is this difference in risk whichis the primary reason for the distinction between stock-holders and bondholders. The bondholder gives up hischance of a high income for the assurance, or imaginedassurance, of a steady income. The stockholder gives upassurance for the chance of bigger gains.

The existence of this risk, tending as we have seen toraise the rate of interest on unsafe loans and lower thaton safe loans, has, as its effect, the lowering of the priceof stocks and the raising of the price of bonds from whatwould have been their respective prices had the risk inquestion been absent.

In the last few years, however, this disparity has beendecreased from both ends. The public have come to be-lieve that they have paid too dearly for the supposedsafety of bonds and that stocks have been too cheap.Studies of various writers, especially Edgar Smith 6 andKenneth Van Strum 7 have shown that in the long runstocks yield more than bonds. Economists have pointedout that the safety of bonds is largely illusory 8 sinceevery bondholder runs the risk of a fall in the purchasingpower of money and this risk does not attach to the samedegree to common stock, while the risks that do attachto them may be reduced, or insured against, by diversifi-

’ Smith, Edgar L. Common Stocks as Long Term Investments. NewYork, The Macmillan Company, 1924.

’Van Strum, Kenneth, Investing In Purchasing Power. Boston , Bar-ron’s, 1925.

"See The Money Illusion. Also When Are Gilt-Edged Bonds Safe?Magazine of Wall Street, Apr. 25, 1925.

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