One of the most important components of becoming a successful investor is learning about balancing your portfolio. With a balanced, well-diversified portfolio, you can be systematically protected against future sources of risk in a way that is otherwise impossible.
Though balancing your portfolio will not guarantee that you earn a substantial return on your initial investment, it is certainly something that is both safe and smart.
With seemingly countless variations of financial assets to potentially choose from, finding ways to effectively balance risk and reward can sometimes be quite difficult.
Though the principle of diversification—investing in multiple different kinds of assets—is relatively straightforward, creating the ideal portfolio will still require a significant amount of effort.
Fortunately, there are still many approaches to investing that have been effectively proven to prevail over time. One of the simplest ways to create a well-rounded financial portfolio is to mix investments in stocks and bonds in accordance with your risk preferences.
This article will briefly examine the time-tested strategy of blending stocks and bonds. It will also discuss how, even as someone who is new to investing, you can begin to create a better portfolio.
Understanding Stocks
Essentially, a stock is a legal claim to a portion of a publicly traded company. The value of a company, in theory, is determined by the amount of equity it owns in the status quo as well as its potential ability to accumulate additional equity in the future.
If a company is currently valued at $1 million and has issued 100,000 equally priced shares, each of these shares will be worth $10 in the status quo. If the company’s value increases to $2 million, the shares will double in value to $20.
Similarly, if the company’s value decreases to $500,000, each of the shares will drop in price to be worth only $5 each. Most publicly traded companies operate on a significantly larger scale than this simplified example.
However, the fact that stocks can sometimes increase in value and sometimes a decrease in value remains quite clear. Because of this, stocks are considered to have an increased level of risk that you will not find in most bonds and annuities.
Generally speaking, there are two primary types of stocks. Common stocks enable you to vote on various company issues—the more stocks that you own, the more votes that you will get (but you don't have to vote).
Preferred stocks do not provide you with voting rights, but they do give you preferential treatment in the event that the company goes under. Additionally, many of these stocks will pay shareholders quarterly dividends depending on how much has been earned by the company.
Most people invest in common stock over preferred stock (preferred stocks require some extra knowledge before investing).
Understanding Bonds
When learning about balancing your portfolio, it is very important to look at the bond market and the stock market simultaneously.
While stocks are generally considered to be a financial asset that has a high potential for reward and high potential for risk, bonds are considered to be the opposite (low risk, low reward). By definition, a bond is the right to claim a future series of cash flows that will be paid by either the government or an issuing corporation.
The riskiness of investing in a bond will be graded by several organizations (Moody’s, S&P, etc.). Because some corporations may not be able to fulfill their promises to their bondholders, “junk” bonds are an exception to the low risk, low reward rule mentioned above.
However, the most important thing to understand about bonds is, unlike stocks, they are fixed income investments. This means that if everything goes as planned, you can predict exactly how much a specific bond will yield.
Diversification and Inverse Correlations
Generally speaking, the safest bonds you can possibly invest in are bonds that are issued by the United States Federal Government. As of November 2018, a 10-year bond issued by the USFG produces an average yield of about 3.16%.
This figure is significantly lower than the return you might be able to earn by investing in the stock market, however, many individuals still enjoy investing in government-issued bonds because the future return on investment is essentially guaranteed.
Diversification is undoubtedly one of the most important principles to maintain when balancing your portfolio. Not only should you invest in multiple types of stock (something that can be easily achieved by investing in an index fund), but you should also invest in multiple types of assets.
Because stocks and bonds generally have a reverse price correlation—when one goes up in price, the other will typically go down—investing in both types of assets can help effectively decrease your exposure to systematic risk.
Determining Your Risk Preference
The portion of your portfolio that is invested in bonds and the portion of your portfolio that is invested in stocks should be determined by your personal level of risk preference. Because stocks offer a higher level of risk and a higher level of the reward than government-issued bonds, individuals who have higher risk preferences will natural construct their portfolio to be more heavily weighted with stocks.
Conversely, individuals who have lower risk preferences will likely have a portfolio that is more heavily weighted in bonds. As your risk preferences change over time—whether this is because of changes in the market, your personal financial situation, or your investment philosophy—you can adjust your portfolio’s risk-reward ratio by shifting your wealth from bonds to stocks (or vice versa).
Your risk preference will be a very personal thing. But regardless of what your risk preference may be, balancing your portfolio is something that should be done with these valuable principles in mind.
