An investment portfolio, and the underlying asset allocation which makes up the portfolio, is typically designed based upon attributes unique to the investor, such as risk tolerance and time horizon, as well as factors external to the investor. Such external factors include market conditions, macro and micro economic factors, individual security analysis, as well as a large variety of other factors, the details of which will not be discussed here. Here we will focus on two factors which are unique to each investor: the investor’s time horizon and the investor’s risk tolerance. By varying the amounts of stocks, bonds and other asset classes based upon these two factors a portfolio can be designed and managed to meet an investor’s goals and objectives.
Investments with greater returns typically have greater risks, and investments with lower returns typically have lower risks. An investor with a long time horizon can afford to suffer through market downturns; and for this reason could have a larger amount of risky, high return investments than an investor with a short time horizon. An investor with a short time horizon should have a higher concentration of lower return, lower risk investments than an investor with a longer time horizon.
An investor with a high risk tolerance can afford to hold a larger concentration of high risk, high return investments than an investor with a low risk tolerance. Such an investor will be less likely to become upset during a market decline and sell their investments. This is a critical aspect of portfolio design and construction, particularly for individual investors. An investor with a low risk tolerance would be more likely to become upset and sell risky investments during a market downturn, incurring a loss. Such an investor should therefore hold a larger concentration of lower risk, lower return investments, as such investments will be less likely to decline in value by significant amounts.
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.