When you start investing, you need to understand the different roles that stocks and bonds play in your portfolio. They are more than just income generation or growth. It’s important to familiarize yourself with each type and some different strategies you can use. This way, you can make more informed decisions. These decisions can help you achieve your financial goals.
Differences Between Stocks and Bonds
Stocks represent an ownership share in a publicly traded company. They are usually more volatile than bonds, which are considered loans to the issuer. Having a predetermined mix of stocks and bonds in your portfolio can help balance volatility levels. A strategic asset allocation of stocks and bonds can also have tax benefits.
Volatility of Stocks
Stocks are known for their volatility. Investors bid on them, and profits are not guaranteed. For these reasons, greed and fear can sometimes overwhelm the market. Strong companies are often sold for less than their true value during market downturns and economic slumps. They are sold for much lower prices than they should be.
Volatility of Bonds
Bonds are generally less volatile than stocks. However, bonds can also experience significant price fluctuations. This was true during the market collapse from 2007 to 2009. Investment banks were declaring bankruptcy and scrambling to raise cash by any means possible after the housing bubble burst. These banks flooded the market with vast amounts of fixed-income securities, leading to falling prices.
How Can You Stabilize Your Portfolio?
Stocks and bonds together can help balance volatility in your portfolio. By combining the two in a calculated way, you are likely to reduce the risks of each. This can also provide you with enhanced protection against an impending recession or depression.
A common strategy for risk reduction is for an investor to subtract their age from 100. They then use this result as the percentage of stocks in their portfolio, with the remainder invested in bonds. As one ages, the allocation shifts from stocks to bonds based on the age-subtracted-from-100 strategy. Stocks provide growth opportunities when you are younger, allowing time for earnings to compound. Then, when you’re older, more stable bonds can provide you with income.
There are many other strategies you can use to allocate assets in your portfolio. For instance, Vanguard has a list of allocation strategies they use depending on investor goals. You can choose between income allocation, balance, and growth.
Why Is Asset Allocation Important?
In addition to allocation, when choosing a mix of stocks and bonds, it’s important to structure your portfolio based on tax management strategies. Taxes can take a significant chunk of your capital if your assets are not placed in accounts that provide tax advantages for different types of assets.
Taxable brokerage accounts can be a good place to store assets that do not generate much income. Tax-deferred accounts, such as retirement accounts, can be a wise option for stocks that pay dividends and taxable income bonds.
For example, let’s assume you have high-tax-income bonds and non-dividend-paying stocks in your portfolio. You would be tax-exempt on a roughly double rate of cash gains. You could place high-yield bonds in a tax-protected account, like a SIMPLE IRA, while keeping the non-dividend-paying stocks in a taxable brokerage account. This allows you to defer taxes on high cash gains and pay lower capital gains taxes on your stocks if you sell them.
Source:
https://www.thebalancemoney.com/stocks-and-bonds-play-different-roles-in-your-portfolio-4012499
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