Stocks and bonds: how to mix them? - August 05, 2018

Stocks and bonds: how to mix them?

We wrote about stocks, bonds and their respective strengths. Not long ago, we also had an analysis about the probable comeback of the latter. But there’s one topic we haven’t covered so far: how to mix stocks and bonds in portfolios. In this post, we’re going to write about the golden rule. 

To better understand the role of stocks and bonds in portfolios, it’s important to see their strengths (and weaknesses) first. For that, we’re going to shortly describe them. At the end of this post we’ll also write about the most important rule for mixing them in a portfolio.

Stocks have higher returns

A stock is basically a part of a company. Investors usually buy these for two reasons. One of them is that many stocks pay dividends to their owners. These provide a constant revenue. The other reason is to sell them later at a higher price. Since the price of shares tends to rise over time, they have every chance to do so. Dow Jones, for example, rose considerably in the last 100 years. As it can be seen in the chart below, S&P also grew more than 70% in the last five years, which is the minimum advised length of an investment.

Performance of the S&P500 in the last 5 years

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If a company does good, so does its shares. What’s more, companies theoretically have an infinite possibility of growing, so their stock prices can rise infinitely, too. But (and this is rather important) this isn’t guaranteed at all. Companies can also have bad periods, so their stocks can fall just as well. Selling them during these times might be a bad idea, but dividends are paid then, too. Altogether, this doesn’t mean that stocks aren’t safe investments. All around the world, authorities and laws are controlling these companies. Still, stocks are volatile, therefore they have a risk. This means that caution and/or professional guidance is important when someone is planning to investing in them.

Bonds are safer

Bonds don’t have such high returns as stocks, but they are safer. Government bonds are basically loans given to the country that issued the bond. This means that they are payback promises which are backed by countries. Developed countries are rather trustworthy in this sense, but they also pay less. The less risk the investors take, the less return they will have. The same is true for corporate bonds, which are backed by companies instead of countries. Higher return means higher risk in their case, too. Still, bonds are beloved investments for more than 500 years, for the very reason of safety.

Yields of major 10 year government bonds

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What’s more, as market reached an important milestone this year, bonds will have their big comeback soon. Up until now, developed governments paid rather small returns on their bonds, around 0-2%. As central banks are hiking rates and ending their QE programmes, this is going to go back to around 3%. Now US and Canadian bonds lead the pack, but we expect that other countries will follow their lead. This means that someone can invest money in US bonds with a yearly 3% return almost risk-free.

How to mix these two?

The rule of thumb of mixing stocks and bonds in a portfolio comes from their respective strengths and weaknesses. Stocks yield higher returns, but they are less safe. Government bonds have smaller returns, but they are safer. This leads to the golden rule: the closer someone is to retirement, the less stocks and more bonds they should have. This is true vice versa: young investors can focus on stocks and higher returns, as they have more chance to rethink their strategies and portfolios even if a fall hits the stock market. But as someone is getting older, the less risk they should take, and bonds are the less risky instruments to invest in.

Mixing them is good for another reason, too. When stock markets are bearish, bonds are often used as safe havens. This is especially important at a time when pension systems are crumbling around the world and retirement age is rising globally. Preparing for retirement and financial self-care will be more and more important as time goes by. This brings well-designed portfolios to the table as well, with a proper balance between stocks and bonds.

Disclaimer: This analysis is for general information and is not a recommendation to sell or buy any instrument. Since every investment holds some risk, our main business policy is based on diversification to minimize threats and maximize profits. Innovative Securities’ Profit Max has a diversified portfolio, which contains liquid instruments. This way, our clients can maintain liquidity, while achieving their personal investment goals on the long term.