When saving for retirement, it is important not to put all your eggs in one basket. Choosing more than one type of investment vehicle will allow you to minimize the risks and maximize your returns. Stocks and bonds are the two most common types of investments that you can consider. Understanding how stocks and bonds work will help you in allocating for your retirement.
In a nutshell, stocks are equities while bonds are debts. A stock is a kind of investment that one purchases in the form of securities or shares in a corporation. During the establishment of the corporation, the shareholders signify their ownership on the corporation’s assets and future earnings through stock certificates. A bond, on the other hand, is similar to an I.O.U., which is a debt security, bill, note or debt obligation. Purchasing a bond from an issuer, which includes the government, municipality, corporation and federal agency, is like lending money to the issuer. The issuer, in turn, provides a bond that promises payment of a specified interest rate during the life of the bond. In addition, the issuer of the bond also repays the face value (principal) of the bond upon maturity.
Types of Stocks
Stocks come in two basic classifications -- common and preferred. Common stocks allow the shareholders to receive dividends and cast their respective votes during meetings of the stockholders. Preferred stocks do the exact opposite. Stockholders do not have the right to cast votes. However, stockholders have a much bigger share in terms of claiming assets and earning profits.
Types of Bonds
The four common types of bonds include U.S. government securities, municipal bonds, corporate bonds and mortgage-backed securities. Issued by the U.S. Department of Treasury, U.S. government bonds obligate the government to pay the bondholder a sum of money (including interest earned) at specified intervals and to repay the total face value or principal upon the bond’s maturity date. Also known as, “munis,” municipal bonds come from state or local governments to fund civic projects. Corporate bonds are debt instruments issued by companies backed by individual corporations to raise capital. A mortgage-backed security comes from pooling mortgage debt and selling it as individual bond securities. Of the four, a mortgage-backed security has the highest risk and it pays principal and interest periodically, unlike other types of bonds that pay the principal upon maturity.
Benefits and Advantages
Compared to bond portfolios, stock investments yield higher returns. A stock provides you a share of ownership in a company. When you have stocks in a company, you are a shareholder, which means you have a claim on the company’s assets, as well as voting rights in company matters. On the other hand, bond portfolios are, considerably, sound. Investing in bonds is less risky than investing in stocks. Unlike stocks, bonds guarantee payment, of not only interests made, but also the original face value itself.
Risks and Returns
In general, stocks offer higher returns than bonds; however, they also have higher risks compared to bonds. Most aggressive investors choose stocks while the conservative ones choose bonds. It is advisable that if you’re willing to take the risk, you should begin with a diversified market portfolio. Try “dialing down” the total risk with the addition of fixed income to the mix. Evaluate your risk-return spectrum by mixing stocks and bonds. If a riskier portfolio holds 100 percent stocks, and the least volatile portfolio holds 100 percent bonds, you can try doing standard stock-bond allocations such as 80 percent stocks combined with 20 percent bonds, 60 percent stocks combined with 40 percent bonds, 40 percent stocks combined with 60 percent bonds and 20 percent stocks combined with 80 percent bonds. Compare the average annual return and volatility of each combination based on the portfolio’s historical performance that may repeat in the future. Analyzing the risk-return will help you visualize the range of potential outcomes based on how aggressive your strategy is.
- Texas State Securities Board: How to Choose an Investment
- GetSmarterAboutMoney.ca: Using the Investment Pyramid
- Fidelity Investments: Choosing the Investments that are Right for You
- MoneyWatch.com: Are Stocks Actually Safer than Bonds?
- CNBC: Buying Stocks or Bonds is ‘Gambling’: John Bogle
- Incademy: Investing in US Markets
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