Understanding your risk tolerance is an important first step in helping your financial advisor create a portfolio that meets your specific goals. Different risk tolerance levels will dictate what offerings a financial planner can prepare for you. For example, people who identify with an aggressive risk tolerance level may have a portfolio consisting of significantly more stocks than bonds. On the other hand a person who is conservative in their risk tolerance, or risk averse, may have a portfolio consisting largely of bonds with minimal stocks. In today’s post, we’re examining the difference between stocks and bonds and how they relate to risk level and your end goals.
While stocks and bonds are often lumped together, it’s important to understand that they are distinctly different. A stock, or stock shares, represent ownership in a company. These shares are traded on the stock market at current market value and are tied to the valuation of a company. As a company’s value increases the value of the stock holdings increase as well; the reverse is also true, when a company’s value decreases the value of the stocks decrease. When a company issues dividends (realizes profits) the dividends are distributed to shareholders.
The well-known phrase ‘buy low and sell high’ refers to the simplified notion of how to make money through stock selling. When a company goes ‘public’ it means they are dispersing ownership of the company to shareholders, i.e. the ‘public’, through stock holdings. Private companies are privately held and therefore do not have shareholders or stock issuances.
Stock markets trade in equity markets and involve varying degrees of risk. The intention of equity markets is to leverage the risk to yield higher returns. Operating in equity markets or trading stocks involves much greater diligence and follow-up than investments in fixed income markets.
Fixed Income Markets
Bonds are traded in fixed income markets, also called the debt securities markets. Bonds are a long-form loan to a corporation in which that issuing corporation promises to pay the owed amount plus interest by a specific date. Bonds typically have a fixed interest rate associated with specific terms. While many consider bonds to be less risky than stocks, it is important to remember that all investments entail a degree of risk — including bonds. Universally the least risky bonds are ones backed by the U.S. Treasury. These types of bonds are said to be backed by “the full faith and credit of the United States”. Investment-grade bonds are bonds backed by companies with the best bond repayment history. Companies like Johnson & Johnson or Verizon are examples of high-rated companies that offer industry-grade bonds. On the other end of the spectrum there are bonds that are more risky, these tend to have higher payouts to cover the risk, called ‘high-risk’.
Interest rates play a huge factor in the price of bonds. When interest rates rise the price of existing bonds drop. This is because bonds issued at new higher interest rates are more valued options to purchase than bonds offered at the lower rates. Purchasing a bond at a higher interest rate will yield higher returns.
Creating a Financial Plan to Meet Your End Goals
As a general rule investors with high risk tolerance will want to weight their portfolio with more stocks than bonds. These type of investors may be younger investors with more time to ride out the inevitable highs and lows in the market. Investors with low risk tolerance will want more bonds than stocks. These investors may be closer to retirement and may not be okay with risking significant losses. Because each person’s financial goals are different, it’s important to create a personalized financial plan for you. Let our expert financial advisors help you figure out what plan is best for your financial situation.
For more information on how inflation rates may affect your financial portfolio, contact us or your financial advisor. Let our expert financial advisors help you figure out what plan is best for your financial situation.