As an investor, it is important to gain an understanding (no matter how generalized) of what you are investing in. Let’s start with stocks and bonds (and cash). What are they?
Stocks are typically ownership shares in a company. As an owner of a stock, you are technically an owner of the company. Pause, and let that sink in. Think about all the stocks you may own (individually or in a mutual fund) and then say to yourself, “I own that company”.
As an owner you accept the many risks that could result. On the other hand, your expected return for the risk associated with ownership is greater; and you usually get to participate in the earnings of those companies in the meantime.
Stocks are the most effective tool for those seeking to accumulate new wealth over time. But along with higher expected returns, they also expose us to a much bumpier ride (volatility), and increased uncertainty that we may not ultimately achieve our goals (market risk).
Bonds are a form of debt. If a company or government needs to raise money, they’ll often ask to borrow it. Now, pause and let that idea sink in. If you own a U.S. Treasury bond, for example; you have loaned the government money.
In return for lending money, as an investor you are entitled to an interest rate to make it worth your while. Because bonds are often secured by property and governed by a specific agreement, they typically are considered less of a risk, and as a result they usually return less over time than compared to stocks.
Bonds are a good tool for dampening that ‘bumpy’ ride and serving as a safety net for when market risks are realized. They can also contribute modestly to a portfolio’s overall expected returns, but we don’t consider this to be their primary role.
Cash – While we talk about stocks and bonds as the two primary forms of investment, what is your alternative. Probably cash. So what is the problem with cash?
Simple, as an investment, in the face of inflation, cash and cash equivalents are expected to actually lose buying power over time, but they’re great to have on hand for near-term spending needs.
A simple guide for stocks, bonds, and cash:
|Expected Long-Term Returns||Highest Purpose|
|Stocks (Equity)||Higher||Building wealth|
|Bonds (Fixed Income)||Lower||Preserving wealth|
|Cash||Negative (after inflation)||Spending wealth|
By keeping your attention focused on the larger principles guiding investment in stocks and bonds, it becomes easier to recognize that each type of investment in your overall portfolio serves a specific purpose in your total wealth management plan.
Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina. Contact us to learn more about our services.