Stocks Versus Bonds

Sat, Oct 23, 2010

Investment


Hi NeedMoney readers,

James here with some basic talk about stocks and bonds. Many novice investors do not understand the difference between stocks and bonds, and their appropriate place within your retirement and savings portfolios. When you own a stock, you actually own a piece of the company. When the company does well, then the stock can soar making you huge returns. Conversely, if the company fails, then an ownership stake in it becomes worthless and your stock can go to zero. When you buy a bond, you are in essence lending money to the company selling the bond. The bond (loan) pays you a defined interest rate. The bond obviously can not go higher in value than the amount owed to you on it (the face value). Therefore, a bond has a much more limited upside, but the risk is far less seeing bondholders get paid in full before stock holders see the first penny.

So when should you buy bonds versus buying stocks? Most experts agree than when you are relatively young (under 40) and investing for retirement, then your portfolio should be heavily weighted towards stocks. Over a long course of time, stocks will almost always outperform bonds. However, over the short term (as we’ve all recently witnessed) stocks can go down substantially. Consequently, when you are older and might need the funds in a relatively short horizon (less than 10 years) you should weight your portfolio more towards bonds. When in retirement, your portfolio should be fully weighted towards bonds. Keep in mind that bonds entail risk too. During the recent financial crisis, many highly rated bonds issued by large banks fell substantially. The only ultimately secure investment are U.S. T-Bills, and this is where funds should go that you don’t wish to take any risks with.

The next time you are asked to fill out a form deciding the allocation between stocks and bonds in your 401K account, just don’t blithely pick a number. A brief consultation with a financial expert who can review your situation can make a world of difference when your retirement years eventually arrive.

James

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