Stocks and Bonds Play Different Roles in Your Portfolio

Used Together, They Can Balance Out Volatility

Market maker
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Stocks and bonds are both common investment instruments. Each comes with its own nuances. How much you should invest in either of these asset classes depends upon many factors: your age, your goals, and your risk tolerance. And, of course, it depends on the amount of capital you have to work with.

When you begin investing, you should learn about the different roles that stocks and bonds play in your portfolio. It's about more than just generating income or growth. It is important to get to know each type and some different strategies you can use. That way, you can make more informed decisions. These can help you meet your financial goals.

Learn more about the differences between stocks and bonds and the roles they can play.

Key Takeaways

  • Stocks represent an ownership share in a publicly traded company. They tend to be much more volatile than bonds, which are a loan to the bond issuer.
  • Combining a predetermined mixture of stocks and bonds in your portfolio can help to balance volatility levels.
  • Strategic asset placement of different stocks and bonds can have tax advantages, too.

How Are Stocks and Bonds Different?

A share of stock represents ownership in a business. For instance, let's say you own a sandwich cart and divide it into 10 pieces. In that case, each of those pieces (shares) is entitled to a 1/10 cut of the profits or losses. If the business is publicly owned, those 10 shares are bought and sold on the stock market. If you own all 10 shares, you own 100% of the enterprise.

The stock market is similar to a real-time auction. Existing and potential owners bid to buy equity (ownership) in publicly traded companies, such as the sandwich cart.

Note

Many people believe that bonds are safer than stocks. But it is more accurate to say that stocks and bonds face different risks. They also respond differently to market swings.

A bond represents a loan made by the bond purchaser to the bond issuer. Sovereign bonds are issued by nations; municipal bonds are issued by municipalities, And corporate bonds are issued by corporations. 

Let's go back to the sandwich cart. Now, let's say you issued a $10,000 fixed income bond to an investor at a coupon rate of 4%. You would receive the money from them; then, you would owe them 4% of the face value of the bond per year. You set a date for the bond to mature. At this point, you return the principal to the investor.

Bonds can then be traded by investors on the secondary market. The prices they are willing to pay will vary based on prevailing interest rates. Put into simple terms, if rates rise, prices on existing bonds generally fall. The opposite is true if rates fall. Existing bond prices rise because there will be more demand for the higher-rate bonds.

How Volatile Are Stocks?

Stocks are known for being volatile. Investors bid for them; profit is not assured. For these reasons, greed and fear can sometimes overwhelm the market. Strong enterprises have been basically given away during a market and economic downturn. They have sold for far less than what they should have been worth.

On the other hand, there have been periods in which non-profitable businesses trade at high valuations. Sometimes, they are completely detached from their real value. An example of this was in 1999: the dotcom bubble was fully inflated. Investors were irrationally exuberant in their expectations of the future returns of internet-based companies. When the realization sank in that these companies were overvalued, the bubble burst. It caused the market to crash.

Tip

A good strategy for avoiding an investment bubble and the burst that follows is to stay away from the trending investments at any given time. Many people have lost large sums by following trends.

Here's another reason stocks can be complicated. A business that has made generations of people wealthy, such as The Hershey Company, can suffer a period of loss. For instance, from 2005-2009, their stock slowly lost 55% of its market value. This was despite an increase in earnings and dividends. 

How Volatile Are Bonds?

Bonds are typically less volatile than stocks. But bonds can experience extreme fluctuations in price, too. This was true during the 2007–2009 market meltdown. Investment banks were declaring bankruptcy. They were trying to raise cash in any way possible after the housing bubble burst. These banks dumped huge quantities of fixed-income securities on the market. And this drove down prices.

Important

A few types of bonds have built-in protection against volatility, such as the Series EE savings bonds. These bonds can be redeemed for their present value, including any early redemption interest penalty you may trigger, regardless of market conditions.

A business's ability to repay its interest liabilities is generally measured by its interest coverage ratio. This is earnings before taxes and interest divided by interest expenses. What if the bond issuer has a good interest coverage ratio and can pay the bond's principal when it is due? In that case, the major risk of investing in bonds is the fact that they represent a promise of future repayment in fixed, nominal currency. In other words, when you buy a long-term bond, the risk you take is that purchasing power will drop dramatically in the long run.

For instance, a $10,000 long-term bond could give back your $10,000 when it matures. But it may not be valued the same as when you bought it. That's because money loses value over time due to inflation. You might not even recoup the inflation loss through coupon payments. Also, your returns could be less than they would have been if you had invested in stocks. That means there may be an opportunity cost as well.

How Can You Stabilize Your Portfolio?

Used together, stocks and bonds can balance out the volatility in a portfolio. By combining the two in a calculated manner, it is likely that you can reduce the risks of each. It can also give you a strengthened defense against the arrival of a recession or depression.

A common strategy to mitigate risk is for an investor to subtract their age from 100. Then, use that result for the percentage of stocks in their portfolio with the rest invested in bonds. As you age, you transfer stocks to bonds based on the 100 minus your age strategy. The stocks give the opportunity for growth when you're younger. It also gives time for gains to compound. Then, when you're older, the more stable bonds can provide you with an income.

There are many other strategies you can use to allocate assets in your portfolio. Vanguard, for example, has a list of the allocation strategies they use depending on investor goals. You can choose between income, balanced, and growth-based portfolio allocations.

Why Is Placement of Assets Important?

In addition to allocation, it's important when selecting your mix of stocks and bonds that you divide your portfolio based on a tax management strategy. Taxes can take a large portion of your capital from you if you do not have your assets placed in accounts that have tax advantages for different types of assets.

Note

The exact same stocks and bonds, in the exact same proportions and tax brackets, can lead to wildly different net worth outcomes. It's all based on the structures in which those securities are held.

Taxable brokerage accounts can be a good spot to stash assets that don't generate a lot of income. Tax-deferred accounts, such as a retirement account, can be a wise choice for dividend-paying stocks and bonds with taxable interest income.

For example, let's say you had bonds with a high taxable interest income and non-dividend paying stocks in your portfolio. You'd be taxed at almost double the rate of cash dividends. You could place your high-yield bonds into a tax-advantaged account, such as a SIMPLE IRA, and hold stocks that don't pay dividends in a taxable brokerage account. This allows you to defer taxes from high-yield dividends. And you could pay the lower capital gains tax on your stocks if you sell them.

Article Sources

  1. Fidelity. "Bond Prices, Rates, and Yield." Accessed June 9, 2020.

  2. Vanguard. "Vanguard Portfolio Allocation Models." Accessed June 9, 2020.