Stock portfolios, by definition, contain only equities. However, people use the term to refer to the broader category of diversified investment portfolios containing equities, bonds and cash. The asset mix — the proportion of stocks and bonds in a portfolio — depends on an investor's financial objectives and market conditions. The mix also determines portfolio returns because equities and bonds perform differently over time.
Bonds provide periodic interest income and safety of principal. The interest is a function of the par or face value of a bond and the stated coupon or interest rate. Depending on market conditions, bonds may trade at, above or below their respective par values. Stocks provide capital appreciation and dividend income. Some companies declare periodic or one-time cash dividends to their shareholders. Publicly traded companies that consistently grow their sales and earnings usually see their share prices rise over time. Market volatility can affect short-term prices of both stocks and bonds.
Bond returns include the regular interest payments and potential capital gains. Investors who actively trade bonds could realize capital gains by buying bonds at a discount to par and selling them at higher prices. The interest payments do not change. For example, a $1,000 par-value bond with a coupon rate of 5 percent pays $50 in annual interest. Stock dividend income depends on the number of shares. For example, a portfolio with 100 shares of a company that pays a 50-cent quarterly dividend would get $50 each quarter regardless of the share price. Companies often increase their annual dividend payments and some declare special one-time cash dividends. The capital appreciation potential is higher for stocks than bonds, and equities have consistently outperformed bonds over the long term.
Adverse business circumstances and poor management execution usually mean a declining share price. The stocks of companies in economically sensitive sectors, such as retail and technology, tend to do poorly during recessions. The main risk for bondholders is that issuers with financial difficulties may not be able to make the periodic interest payments or repay the principal on maturity. Government and high-quality corporate bonds generally pay less interest because of the lower levels of risk, but lower-quality bonds must pay higher interest rates to compensate for the higher level of risk.
The equity-bond asset mix can change over time. For example, 20-something investors may prefer an aggressive 70-30 equity-bond mix in their portfolios because they are willing to accept the higher risk in order to achieve above-average capital appreciation. However, retirees may prefer a conservative 30-70 equity-bond mix to ensure safety of principal and regular cash income. Investors should rebalance their portfolios to maintain the target asset mix. For example, if a market rally has changed the target asset mix from 50-50 to 60-40 equity-bonds, rebalancing may involve selling equities and buying bonds to restore the target mix.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.