A well-balanced portfolio, according to most personal finance experts, should contain a mix of both equities (also known as stocks) and bonds. What the precise ratio of equities to bonds should be depends upon a person’s age and willingness to tolerate risk, as well as other factors. However, in general balancing a portfolio with both equities and bonds is an essential way of diversifying and avoiding unnecessary risk.
Equities and bonds are two of the most common and well-known investment vehicles, but they are actually quite different products. Stocks are shares in the ownership of a company; people who buy stocks essentially become owners of (a minute fraction of) a company. When the company does well, the stock price generally rises and the shareholders prosper. In contrast, if the company does poorly, the shares fall in value, and the shareholders lose money.
Bonds, in contrast, are essentially loans. The “bond” itself is the contract which specifies the amount to be loaned (the bond “price”), the interest payments which will be made, and the date at which the bond “matures,” or is paid back in full to the bondholder. Because the profit from a bond is established in advance, bondholders do not necessarily stand to do better if the company grows or shrinks, although bond prices will adjust somewhat if the interest rates of newly issued bonds rise or fall. Still, barring a total collapse of the corporation, bondholders will always receive the interest promised to them, even if the company does poorly and its stock value falls.
Because the two products are very different, including both of them in a personal investment portfolio is a way of reducing unnecessary risks. Although stocks offer the potential for much greater growth than bonds, they are also much more volatile. Investing in bonds is therefore a way to provide a more stable and secure component of an investment portfolio.
In addition, in many cases the prices of stocks and bonds are inversely related: that is, when stock prices fall, bond prices often rise (and, of course, vice versa). Nervous investors flee to the apparent security of the bonds market when the volatility of the stock market grows too much for them. Buying both equities and bonds, then, is a way of diversifying to ensure that at least some portion of the portfolio has some chance of growing at all times. At all times, bond prices do respond to changes in prevailing interest rates: when interest rates rise, the price of existing bonds falls (because lenders want to issue new bonds at the higher rates), but when interest rates fall, the price of existing bonds rises.
In general, the precise value of the balance between equities and bonds depends upon risk tolerance, and financial advisors usually advise that it should vary with age. Younger people, who do not expect to need their lifetime savings for decades yet, can afford to invest relatively little in bonds, and take their chances on the stock market, knowing that a few unexpectedly poor years should be offset by good years over the long run. They may opt, for example, to invest 75-80% in equities, and just 20-25% in bonds.
However, as we age, the date at which we will be drawing on our investments to support us grows nearer – and, therefore, our appropriate level of risk falls. This is because it is difficult to predict in advance in which months or even years the stock market will suffer substantial losses – and nobody wants to see the stock market, and their portfolio along with it, plunge by one-third just as they’re preparing to leave the office for the last time. Bonds allow the prospect for some growth, while avoiding the greater volatility of the market; therefore, older people are advised to hold a higher percentage of bonds in their investment portfolio. One common rule is that the percentage of equities should be 100 minus your age – or, put another way, the percentage held in bonds should be equal to your age. This means that a 25-year-old should invest 25% of their savings in bonds, but a 65-year-old should have at least 65% invested in bonds.