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When you first come across investing, you may be told to diversify your portfolio by investing in both stocks and bonds. But what exactly are stocks and bonds and what is the difference between the 2? Moreover, how should you allocate your portfolio accordingly? This article is a simple easy to understand guide to investing in stocks vs bonds
Bond market (debt) vs stock market (equities)
The bond market is where investors go to buy and sell debt securities which are issued by corporations or governments in contrast to the stock market where investors go to buy and sell equity securities such as common stocks which are traded on stock exchanges, with the NASDAQ and the NYSE being the most prominent stock exchanges in the US.
Bonds essentially represent debt. A government, corporation, or other entity that needs to raise cash borrows money in the public market and subsequently pays a fixed income or coupon on that loan to investors. Once the bond matures, the investor is returned the full amount of his original principal, providing that the issuer does not default or fail to pay on his debt obligations.
Stocks on the other hand, represent an ownership stake in a company. Should you wish to invest by buying shares in a particular company, you are essentially purchasing an ownership stake in a company, meaning that you have a share in the profits of the company that you invest in if it performs very well and its value increases over time. However, you also run the risk that the company you invest in could perform very badly and the stock could go down or in the worst case scenario disappear altogether via bankruptcy.
What asset class is right for you?
Individual stocks as well as the overall stock market tend to be on the riskier end of the investment spectrum in terms of their volatility, as well as the risk that the investor could lose money in the short term. However, they also tend to provide superior long-term returns. The key here is to think long term and don’t put all your eggs into one basket. The easiest way to do this is to invest in a broad market index fund such as the S&P for example via a low cost broker such as M1 Finance. Bonds on the other hand, are considered less risky but lack the long-term return potential of stocks. However bonds are preferred by investors who regard a steady income as a priority. Although bond prices sometimes fluctuate in the market, the vast majority of tend to pay back the full amount of principal at maturity.
Many people invest in both stocks and bonds in order to diversify their portfolio. A young investor who has a longer time horizon and a higher tolerance of risk may wish to allocate more of his portfolio to stocks for example i.e. 80% in stocks and 20% in bonds. On the other hand, another investor that is approaching retirement may wish to preserve his capital and thus, invest more of his portfolio in bonds i.e. 80% in bonds and 20% in equity. Therefore, how you wish to allocate your portfolio depends on your time horizon, your tolerance for risk, as well as your investment objectives.