If you've ever had an ear infection, you know how a seemingly tiny thing can throw off your balance, causing the room to spin and making it difficult to stand up. Your investment portfolio shares a number of the same qualities as your inner ear. Small changes in the financial realm can throw your portfolio out of balance. Maintaining an appropriate ratio between stocks and bonds can help you keep your financial equilibrium.
The U.S. Securities and Exchange Commission refers to the division of your investment assets among diverse categories of securities as asset allocation. The two primary types of investment securities are equities and debt instruments. Equities are commonly represented in your portfolio by stocks, while bonds typically represent debt instruments. Both types of investments involve risk, although stocks are typically thought to offer both higher risks and greater potential reward. Most investors should have both stocks and bonds in their portfolios. The trick is in getting the right mix.
Diversification is the practice of spreading your risk over a number of different investments, so if the bottom drops out of one, you won't lose all your money. The SEC recommends diversifying between and within asset categories. For example, you might have both stock and bond investments with companies in the retail, defense, manufacturing and financial services industries. If the financial services industry as a whole suffers, your investments in manufacturing might prosper, which will help to offset the loss. If the stock market experiences a bear market, the interest from your bonds can still buoy your portfolio.
Balancing Your Portfolio
There is no perfect ratio between stocks and bonds that applies to all investors. Your situation is unique, and your investment portfolio should be designed to match your individual needs. Consider your age, tolerance or aversion to risk, income, available investment capital and ultimate investment objectives. Time is often your greatest ally or your worst enemy when it comes to investing. The general rule of thumb is that the longer you have to invest, the greater the risk you can afford to take. The American Association of Individual Investors' asset allocation models for people with more than 30 years to invest is weighted 90/10 in stock vs bond investments, while portfolios for those with 10 years to invest is balanced 50/50 between stocks and bonds.
We don't live in a static universe, and your investments are impacted daily by changes in the financial climate. Even if you have determined the appropriate ratio between stocks and bonds in your investment portfolio, it is unlikely that balance will be maintained over the long term. The SEC recommends revisiting your portfolio periodically and rebalancing your assets as needed. For example, you might determine a 70/30 ratio between stocks and bonds is best for you. If the market experiences exceptional growth, the value of your stocks might increase to the point that they now represent 80 percent of your portfolio. You would need to sell some of your stocks and reinvest the proceeds into bonds to bring your portfolio back into balance.