Investing basics – stocks, bonds and asset allocation

Many of us have some type of retirement savings accounts set up. And that’s a really important first step toward meeting your goals for the future financially.

The next step is making sure these accounts are invested in a way that best suits you. That means thinking about your risk tolerance, how much time you have to meet your goals and when you might start making withdrawals. 

Why are these considerations important? Because different types of investments—for example stocks versus bonds—have characteristics that cause them to behave very differently. Therefore, based on your particular needs, goals, risk tolerance, time horizon and overall circumstances, it may be important to have the right mix of stocks, bonds and even cash, which would be a general example of an asset allocation.

Let’s take a closer look at the characteristics of the two main asset classes (bonds and stocks) to help you figure out how to choose the right asset allocation now and over time.

Bond

Bonds, which are also referred to as fixed income or debt securities, are typically seen as more conservative investments because their value does not tend to fluctuate as much as equity value. Generally speaking, bond owners also receive a small periodic fixed payment known as a coupon. These characteristics often make bonds appropriate for investors nearing retirement, for whom retaining the value of their assets becomes a bigger priority than growing them. Fixed income can be an appropriate option for investors who are risk averse and are uncomfortable seeing the value of their account go down due to market fluctuation.  Of course, there are various types of bonds not discussed here that carry different levels of risk, and not all bond types are suitable for all investors.  As with all investing, you should work with a qualified financial professional to determine which – if any – bond investments might be suitable and appropriate for you.

Stocks

Stocks, which are also referred to as equities, typically have more potential to appreciate over the long term. They represent shares in (i.e., ownership in) a company, and if the company grows over time, so  can the value your shares.

But owning stocks comes with risks, and generally more so than bonds. Sometimes a company does not grow and instead might have a period of lower earnings – maybe it loses money because a competitor comes out with a better product or the management is involved in a scandal. These are just some examples of scenarios that could cause the share price of stock to go down. This fluctuation in equity prices is often referred as volatility, and it can be driven by many factors.  Stock investors must expect volatility and ultimately assume the risk of loss inherent to equity investing.    Of course, there are various types of stocks not discussed here that carry different levels of risk, and not all stock types are suitable for all investors.  As with all investing, you should work with a qualified financial professional to determine which – if any – stock investments might be suitable and appropriate for you.

Asset allocation – finding the right mix 

Even with all of their volatility, and while past performance is never a guarantee of future results, equity investments have tended to increase in value more than bond markets over the long term. That often makes equity investments appropriate for people who have a longer time to let their money grow, for example, at least 10-15 years or more, and are able and willing to accept generally greater downside risk. You should think carefully about your own risk tolerance – will it make you uncomfortable if you see your account balance drop sharply when markets fall? If so, you may feel better with a smaller allocation to equities in your portfolio. For some people, giving up some potential for gains by taking less risk is the right strategy. Feeling comfortable with your investments is important.

Equity volatility is also something you need to consider as you approach the time where you will want to start making withdrawals. Not only might you have less time to ride out any fluctuation in the equity markets, it would also be very unlucky if just when you wanted to take some money out, your account value drops by 20% because the stock market has fallen.

While, as one example, an asset allocation for someone in their 20s might be 100% equities, the conventional wisdom is to slowly change your asset allocation away from equities and toward bonds and cash over time. Once you are in retirement, you may be close to 100% bonds and cash. While the goal of this approach is to shift toward more conservative investments over time as you get older and become less risk tolerant, it’s important to remember that asset allocation does not guarantee a profit or protection against loss in a declining market.

Choosing the right asset allocation between equities and fixed income is a personal decision that will depend on your risk tolerance, your age and even how much you have already saved. And like many aspects of retirement planning, it will change over time as your life changes, so be prepared to work with your financial professional to update it as appropriate and suitable for your circumstances and goals.