Every financial adviser you will meet and every investment article that discusses portfolio diversification will state that you need to place your money in stocks and some of your finances into bonds.
However, you may be wondering why this is so often said. The reason for this is that stocks and bonds usually do not move in the same direction.
This is because whenever stocks rise, bonds tend to fall, and when stocks go down, bonds tend to rise. Therefore, investing in both is a wise means of protecting your overall portfolio.
Why Do Stocks And Bonds Usually Move In Opposite Directions?
Stocks and bonds usually move in opposing directions as they are often fighting for the same investment money.
Whenever investors place their money into stocks, they have less money left to buy bonds. In contrast, whenever investors use their money to purchase bonds, they have less finances available to purchase stocks.
Often, investors will also sell their bonds in order to obtain the money to purchase stocks and vice versa. Whenever this happens, the price of both asset classes will be impacted.
Why Does Investing In Both Stocks And Bonds Provide Protection For Your Portfolio?
Diversifying your portfolio by placing your money in both stocks and bonds provides you with the utmost financial protection because you can offset any losses you incur through one investment with the gains that are made in the alternative investment.
If your stock holdings begin to lose value because prices are declining, your bond holdings can helpfully offset any losses if bond prices are simultaneously rising.
Bond prices usually move on different scales and dynamics when compared to stock prices. Bonds also tend to be a safer investment comparatively.
However, during periods of extreme financial stress, bonds can decline just like stocks. Numerous people chasing out can be detrimental for bonds in the same way that it is for stocks.
Bonds also pay interest, and bond funds will pay dividends that consist of interest accumulated by numerous bonds.
Contrary to what I have outlined, high yield bonds can move in the same direction as stocks, this is one of the reasons why many investors choose not to use them to enhance the volatility and protection within a portfolio.
As mentioned, during periods of extensive financial stress, such as market crashes or during Federal Government monetary changes, bond markets can be drastically impacted, causing them to go down. The following factors can also impact the price of bonds:
- The Federal Government lowering interest rates in order to inject trillions of dollars into the market in order to prevent a recession.
- A flight to cash out bonds – many investors will panic sell their bonds during tumultuous periods of time, inherently causing prices to lower. This is a counterproductive move in the vast majority of cases.
- Bond traders may also enact extreme markups or markdowns on the price of bonds. This usually occurs when they want to move them.
What Does Marked To Market Mean?
A vast majority of investors’ time is spent ensuring that any fixed income holdings are of the highest quality.
However, you cannot alter the fact that whenever a bond is sold for a lower price than the bond is actually worth, irrespective of whether it is a bond that is owned by yourself or within a mutual fund, it will be listed as “marked to market” across all statements and digital dashboards globally.
Being marked to market does not necessarily mean that you need to sell these specific bonds or dump any mutual funds that are holding these bonds.
The cash flows behind these bonds should restore to normal within a matter of weeks within the market, and thus, panic selling is never advisable.
Of course, some companies may go bankrupt and not pay out on their bonds.
However, this can usually be foreseen, which is why it is important to remain updated and well-researched into the market and the bonds that you are investing in.
If your financial portfolio also contains stocks, then the price of these pay rise during this period of time, ensuring that your finances remain balanced.
To conclude, many investors will invest in both stocks and bonds as one usually tends to offset any losses that are incurred by the other.
This is because as the price of bonds drops, the price of stocks usually rises, and vice versa.
This inherently offsets any damages to your portfolio as the gains made in one investment will balance out the losses incurred through the other.
However, some investors choose not to invest in both stocks and bonds as they can move in the same direction from time to time.
This means that any losses would not be offset, and thus, some investors prefer to avoid the risk of this occurring and invest their money elsewhere.
You should always try to avoid panic selling when you invest in bonds, this is because sometimes, bonds can be listed as marked for market due to circumstances outside of your control.
However, these usually return to normalcy within a matter of weeks, and thus, investing in bonds is one of the safest means of storing your finances.
If you are uncertain about whether you want to invest in stocks or bonds, you should consult with a financial advisor who will be able to lead you in the right direction for you.
It is undoubtedly a popular choice for many investors to invest in both bonds and stocks, and this is for the reasons that I have outlined above.
Investing in stocks and bonds is one of the most popular and sensible decisions that you can make if you are looking to protect your financial portfolio because of the tendency for these investments to move in the opposite direction.
However, you should remember that this trajectory is not a prerequisite of the investment.