Stocks versus bonds Which to hold when

A practical guide to understand the relationship between stocks and bonds

Bonds and stocks are both constantly fighting for investors hard-earned money. Bonds and stocks both have different risk profiles, with bonds being much safer than stocks but offering a lower return. As a general rule of thumb when stocks go up in value, bonds of down in value and vice versa.

When Do Stocks Do Well?

Stocks typically perform well in times of economic growth. This is when the economy is in a period of economic expansion and GDP is rising.

This is because consumers are making more purchases resulting companies achieve higher earnings thanks to an increase in demand. Investor confidence rises and more money is pumped into the stock market. To optimize your investment performance in times of economic expansion it is favourable to sell bonds in favour of stocks.

When Do Bonds Do Well?

During times of economic downturn, consumers spend less on goods and services and as a result company profits start to fall and stocks prices decline. During such economic climates investors prefer the safety and regular interest payments that bonds have to offer.

Exceptions To The Norm

It is not unprecedented for both stocks and bonds to increase in value at the same time. This can take place when there is an oversupply of money in the economy and too much liquidity and too few investments. This results in an inflow of capital into both the bond and stocks market. This can often happen at the top of the stock market when there investors that are bullish and others that are bearish.

The opposite can also happen and both stocks and bonds can fall. This is quite a rare occurrence and happens in times of extreme fear when investors panic and sell all their assets, including both stocks and bonds. During such a case gold prices tend to rise as they are considering a safe haven for investors historically and a store of value.

Understanding Stocks and Bonds

Simply put bonds are loans you make to a corporation or the government. Bonds pay a fixed interest payment throughout the lifetime of the instrument. You also receive your principle amount at the end of the life of the bond provided the borrower doesnt default. Typically the higher the interest payments (the higher the yield) of a bond the higher the potential is for the borrower to default.

Bonds can be classified as short, medium or long-term. Short-term bonds mature between one and three years. Medium-term bonds mature between four and ten years and long-term bonds have maturities of greater than 10 years.

A bonds value will fluctuate over time and this allows bonds to be bought or sold on a secondary market before there maturity date.

Stocks on the other hand are shares of ownership in a company. The value of a stock will depend largely on the companys earnings which are typically reported on a quarterly basis. The value of a stock will change based on investors estimates of the future earnings of the company relative to its competitors and relative to the industry.

Which Is Best For You?

When deciding between stocks and bonds you need to consider your personal risk tolerance and financial goals.

If you are young and have a long investment timeline having a greater weighting in stocks may be ideal. This will allow you to be rewarded for undertaking more risk and you will have the luxury of time to ride out any short term market downturns.

However, if you are nearing retirement and need access to your capital in a few years losing your principal amount should be out of the question and thus having a greater exposure to bonds would be recommended. This allows you to receive regular payments without the risk of losing your principal amount.

Most investment professionals would advise being diversified and holding a mix between stock and bonds at all times. An old rule of thumb was that your age should be the percentage of your portfolio in bonds and the remainder in stocks. However, with people living far longer and retiring later this rule has become outdated.

By monitoring the state of the economy you can tweak your mix between stocks and bonds to optimize your returns. If the economy is expanding you can sell some of your bonds and buy more stocks. If the economy is in a downturn your hold more bonds to protect your principle amount while providing cash flow in the form of interest income.