The bulk of many portfolios is a combination of stocks and bonds. Stocks, which are shares in different companies, tend to be considered higher risk and higher return. Bonds, which represent a certain amount of someone else’s debt, are considered lower in both return and risk. So the proportion of each you choose in your portfolio affects your risk, your return, and how your portfolio will respond to different financial situations. What’s the perfect mix of stocks and bonds for your situation?
Stocks are the bulk of most portfolios. Each stock is a certain fraction of a company, so the stock rises when the company is doing well and falls when the company falls on tough times. That means the value of a stock isn’t guaranteed. If its value drops between when you buy it and when you sell it, you’ll lose your investment. However, shares in a stable company that is doing well tend to pay off over time. Most casual investors choose to buy and hold for some time, rather than attempting to make money off the small changes in stock value from day to day. This strategy minimizes your risk.
Because you can lose money on stocks, they’re riskier than bonds, CDs, or money market accounts. But they also tend to give a higher return. The right mix of stocks could give you returns equalling the market growth during the time you hold your portfolio. That could be 10% or even more! However, if the market contracts, all your stocks are likely to lose value at once, and you could have a bad year.
You can pick stocks individually or simply invest in a mutual fund, where stocks are picked for you. Either way, stocks will produce a large proportion of your gains over time.
Bonds tend to be the stable heart of your portfolio. They won’t usually be a majority, but they are the part of your portfolio least vulnerable to market changes. That’s because they don’t represent part of a company, but a certain amount of debt. Bonds are sold in $1000 chunks, meaning that you pay a market-determined price and eventually receive $1000 on the designated date, as well as some amount of interest in the meantime.
It is, of course, possible for the bond issuer to default on their debt. However, corporate issuers have to pay bond holders before stock holders. And the federal government never defaults on its bonds.
However, there’s another risk involved in over-relying on bonds. Because their yield is so much lower than stocks, you might not earn enough to keep up with inflation. In that case, you don’t lose dollars, but you do lose some of the value of your money, if not as much as you would have lost by hiding it under your mattress. In high-inflation markets, you wouldn’t want to rely too heavily on bonds.
Another time bonds can be risky is when you might want to resell them before maturity. Bonds lose value when interest rates go up, because newly-issued bonds are worth more than the old, low-interest ones you’re holding. Invest in bonds with money you don’t expect to need again before the bond’s maturity date. It’s also a good strategy to hold both short and long-term bonds, which will react to market conditions differently.
The Perfect Stock/Bond Mix
As you can see, stocks provide higher returns, but are vulnerable to market changes, while bonds are safer, but might not produce adequate returns. So how do you know which to invest more in?
Traditional wisdom suggests that younger people should invest in more stocks, shifting money into bonds as they get older. If you’re 40 and all your stocks crash, you have 25 years to make up any losses. Making up those losses will be much easier if your gains are high, which stocks can give you. Your longer time horizon also means you need to stay ahead of inflation and maximize your gains as you save for retirement. Early in your savings journey, you might not be able to save very much for retirement. But with the large gains stocks can give you, over the long time period before you retire, that money can grow to a useful amount.
However, if you’re approaching retirement or already retired, a sudden crash could be disastrous. You won’t be able to reinvest in the market because you need that money soon. That’s why seniors tend to have more bonds. Ideally, you should move money you will need in the next five to ten years into bonds and cash.Keep money you won’t need for a long time in stocks, where it can keep producing returns. Even retirees usually have some stocks in their portfolio, to ensure their retirement fund doesn’t lose value during their golden years.
There’s No One Right Answer
The right stock/bond mix is a perennial question. Different experts have different percentages they recommend. Should you start out at 90% stocks, or 70%? Should you have 50% bonds at 65, or 60%? This depends on not only your age and amount of assets, but also your risk tolerance. Nothing is risk-free, but will you sleep better at night holding more bonds? Your financial advisor can run a simulation for you and show you the pros and cons of different asset allocation ratios.If you don’t have an advisor, you can connect with the perfect expert for you by contacting us.