Stocks and bonds are some of the most common assets held in accounts by individuals, such as 401K and IRA accounts. Previously we provided an overview of the asset allocation process and how it can be used to customize your investment portfolio based upon your investment objectives, time horizon and risk tolerance. We also discussed briefly how this process can be implemented in your 401K account. Here we will provide a very basic overview of stocks and bonds.
Stocks are publicly traded equity interests in businesses, and are typically riskier than bonds. As an asset class, stocks are oftentimes broken down by company size (frequently referred to as “market cap” or “market capitalization”) and geographic region, (such as U.S., developed markets, emerging markets, and frontier markets). Emerging market stocks typically can provide a higher return than developed market stocks, but are riskier. As stocks are overall riskier than bonds, they are usually allocated more heavily to portfolios with a longer time horizon and for individuals with higher risk tolerances.
Bonds are debt instruments issued by businesses or governments (both national and local), and are typically less risky than stocks. They are usually allocated more heavily to portfolios with shorter time horizons for individuals with lower risk tolerances.
Holding bonds entails several risks, including credit risk and interest rate risk. Credit risk can be defined as the risk that the issuer will default and fail to make payments of interest and/or principal. Interest rate risk is the risk that interest rates will rise, resulting in a decrease in the present value of the bond principal. Interest rate risk can be somewhat mitigated by holding bonds until their maturity, however this is often difficult for an individual investor who is more likely to be invested in bond funds rather than individual bonds.
Stocks and bonds have different risk and return characteristics. By combining them with other asset classes and weighting their allocation appropriately, an investor can customize an investment portfolio based upon his or her time horizon, investment objectives, and risk tolerance.