Creating an ideal investment portfolio can in some ways be compared to cooking a gourmet meal. You need to understand your ingredients and how they are likely to behave in relation to each other. While bonds and equities can complement each other in an investment portfolio, they serve different roles. Both bonds and equities can be great assets, but when one of them zigs the other often zags. So, it's important to have the right mix of bonds and equites in a portfolio. In most cases, it is the single most determining factor in successful investing
Equities are also known as stocks. Equities represent an ownership stake in a publicly traded company. The owner of equity shares is entitled to a portion of the company's profits either in the form of dividends or capital gains when the value of a company's stock increases. Equities have an important place in a portfolio because they promise the highest returns over time. Equities also carry the most risk. Equity share prices can fall dramatically at times depending on stock market conditions. The key to including equities in a portfolio is having the right proportion. A investor who may need cash soon -- such as college savers and retirees -- would want to limit the amount of equities in his portfolio to avoid the risk of having to sell the investment if stock prices are down when he needs the money. Those with a longer investment horizon -- say, a 25-year-old who is investing for retirement -- has more time to recuperate from losses and to experience gains, so a higher proportion of equities is generally appropriate.
Bonds are a less risky asset class. Investors who purchase bonds are lending money to the government agency or corporation that issued the bond. In return for the loan, the issuer promises to pay the investor a specified rate of interest for the life of the bond and also repay the original loan amount at a specified future date. In other words, bond investors do not own a portion of the bond issuer -- they simply lend it money. The relative stability of bonds helps to balance the risk in a portfolio. Bond interest payments are added to the portfolio at regular intervals whether the bond issuers' immediate growth prospects are good or bad, sowhen stock markets are going down, the value of bonds often rise or at least fall less, which helps to balance out portfolio values during volatile conditions. An investor who wants to limit the risk of losing money in the stock market will want to have a heavier allocation of bonds in his portfolio.
Bond Interest Payments vs. Equity Dividends
The dividend a company pays its equity share holders can potentially go up, which helps investors keep up with the rate of inflation. Bond interest payments, however, stay the same throughout the life of a bond. This can be a good thing when you consider that companies paying dividends can decide to either reduce or eliminate a dividend. But if consumer price inflation becomes an issue, interest payments from bonds may lose their purchasing power, so long-term investors may want to skew their portfolios a bit more strongly toward equities.
Potential for Appreciation
The value of equity shares will reflect the earnings of a company. The stock market has historically returned an average of about 8 percent per year to investors, but many individual companies that offer equity shares will do significantly better or worse than that. On the other hand, over the full course of its life a bond can not earn more than its face value plus whatever the predetermined interest payments are. Portfolios heavily weighted with bonds are likely to maintain a stable, yet slowly increasing value. Portfolios heavily weighted with stocks would likely see more dramatic changes in value over the short and long term.
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