The two most prominent and most important types of investment are stocks, or equities, and bonds. These two asset classes play two very different roles in a person’s investment portfolio, and both are important when it comes to maximizing long-term gains while balancing out the right amount of risk. In this post, we will go over what stocks and bonds are for and why you might want to include both in a portfolio.
Stocks
Stocks are pieces of ownership in a company. For most investors, the fact that they represent ownership is not essential, and what matters is how they behave as assets. Stock prices are meant to reflect how the market feels about a company. The more profitable a company is, the higher its stock price will be. If the company does well in terms of expanding its business or improving its process, then the price will keep rising. The price can also rise if the company appears to be moving towards something good, even if its current financials are not in good shape.
The Role of Stocks
The role of stocks in a portfolio is that stock prices tend to go up over time. Therefore, holding onto a collection of stocks that rise in value is one of the most effective ways to invest and save money. The challenge is that it is not easy to choose the right combination of stocks that will yield reliable and steady growth.
Types of Stocks
Not all stocks are the same. They can be broadly divided into different sectors of industry, such as tech stocks, retail stocks, banking stocks, and so on. Each industry has its own characteristics about how it performs in different economic situations. Choosing stocks from different industry groups is an excellent way to lower the overall risk of the portfolio you hold. If you buy only one stock, or stocks in only one industry, then if something negatively affects that stock or that company, you stand to lose your investment if the stock price goes down.
Mitigating Risk
Spreading out the risk by investing in multiple sectors reduces the risk that something would cause all of them to decline in value at the same time. In general, the stock market as a whole rises year after year. However, specific stocks and sectors can go down and stay down, and the market itself can have bad years, so the high growth is accompanied with risk.
Bonds
Bonds are the opposite of stocks– they have lower returns on investment, but they come with much lower risk than stocks. A stock is a piece of ownership in a company, while a bond is a loan that provides a company or government with money, which they pay back over time. Unlike stocks, bonds do not bounce around in price when the profit of a company looks good or bad. Instead, they provide a steady and slow rate of return.
The Role of Bonds
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Like stocks, bonds are associated with companies in different industries. But, at the same time, there is a separate kind of bond that has no corresponding element in the world of stocks: government bonds. These can be owned by the federal government, state governments, city governments, and even the governments of other countries.
Risks of Bonds
Bonds are not totally free of risk. For example, if the company or the government goes bankrupt, then the holders of bonds might not get their money back. However, this risk is much lower than the risk of the stock price going down, particularly for government bonds.
Diversifying Your Investment Portfolio
Because stocks and bonds perform different roles, most people feel comfortable with a portfolio that involves both of them in different proportions. For example, young people tend to have portfolios that are mostly stocks because they have a long time to save ahead of them, and they can take advantage of the growth potential. On the other hand, people who are older and closer to retirement are more interested in preserving their accumulated assets than growth, so they tend to have a more bond-focused portfolio. However, just about everyone who invests keeps some of their assets in stocks as well as bonds.
If you are interested in learning how to calculate the return on a portfolio, then the best way to is to use a compound interest calculator. Compound interest rates are the rate of return on the investments you hold, so you can enter how much your assets are worth and their current rate of return, then see how much they will be worth at different points in the future. However, keep in mind that this does not include a measure of risk, so you will need to account for how risky the assets are another way.
