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For most investors, the majority of their portfolio will be made up of stocks and bonds. These two assets may be held in the form of mutual funds or ETFs that invest in underlying stocks and bonds, or you may hold positions in individual stocks or bonds directly.
But how do you know whether to own more stocks or more bonds, and should some investors avoid stocks or bonds altogether? Here’s how to know whether stocks or bonds are the better choice for you.
Stocks vs. bonds: What’s the difference?
Before deciding whether stocks or bonds are a better fit for their portfolio, investors should understand the differences between the two asset classes.
- Stocks represent ownership stakes in real businesses and generate returns for shareholders through dividends and capital appreciation driven by the underlying companies’ earnings growth. While stocks have the potential to earn high returns, they can be quite volatile in the short term.
- Bonds are loans made to governments or corporations and typically generate income for bondholders through interest payments. Bonds tend to be less volatile than stocks, but you can still lose money investing in bonds, particularly in a rising interest rate environment.
Risk tolerance
One of the first things you need to understand before making any investment is your own risk tolerance. Risk tolerance is your ability and willingness to take risk, and it has a big impact on the types of investments you should choose.
All else being equal, someone with a high risk tolerance may be more inclined to own stocks because they’re willing to stomach the volatility in exchange for the high return potential. Before investing in stocks, you should ask yourself how you’d feel if your portfolio declined by 20 or 30 percent. While not a frequent occurrence, drawdowns of 20-30 percent (or more) do happen and investors should be prepared for them.
Keep in mind that risk tolerance accounts for both your ability and willingness to take risk. Someone may have a high willingness to take risk, but if they have a large amount of debt and no emergency fund, their ability to take risk may be quite low.
Conversely, someone may have a high ability to take risk, but market volatility makes them nervous and may lead to poor decisions. This person would have a low willingness to take risk and should focus on safer investments like bonds or other fixed-income securities.
Investing goals and time horizon
You’ll also want to consider your investing goals and the time frame for those goals when looking at stocks and bonds. These goals will impact your ability to take risk and influence the types of investments you should consider holding.
Stocks tend to be a better fit for long-term goals such as retirement because of how volatile they can be in the short term. Goals that are at least five years down the road are typically a good fit for stock market investments.
On the other hand, bonds and other short-term fixed income securities tend to be a better option for short-term goals because they are typically less volatile than stocks and can help generate returns above what you’d earn in a traditional savings account. Maybe you’re saving for a down payment on a house or a nice vacation a few years from now. Stocks are probably too risky for these short-term goals, but bonds may boost your returns while still providing the safety you’re looking for.
Asset allocation
When it comes down to it, most people will end up owning a combination of stocks and bonds in their portfolios. When you are far from your goals, stocks will make up a greater portion of your portfolio because their higher return potential and the longer time horizon gives you time to recover from any short-term losses.
As you get closer to your goal, your portfolio’s asset allocation should shift away from stocks toward bonds and other fixed-income securities. For example, once someone reaches retirement, they may want to hold more bonds because of bonds’ ability to generate income once they’re no longer working.
It may be useful to work with a financial advisor to determine the best asset allocation strategy for your portfolio. Bankrate’s financial advisor matching tool can help you find an advisor in your area.
Bottom line
If you’re deciding whether to invest in stocks or bonds, the choice will likely come down to your investing goals and risk tolerance. Stocks typically offer higher returns, but can be volatile in the short term, making them a better fit for long-term investment goals. Bonds tend to be less volatile, but offer lower returns, which makes them a better fit for short-term goals or for investors with a low risk tolerance.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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