Stocks and bonds are among the most common investment types, with most retirement portfolios containing a mix of the two. Stocks are small shares of a company’s equity or ownership. Bonds are loans to companies and governments, which earn interest for their holders.
How do stocks and bonds work?
Generally speaking, stocks contain higher risk with the potential for higher reward, while bonds are the opposite: lower risk, but also less reward. As you get closer to your retirement, it’s typically recommended that you increase your proportion of more stable bonds to riskier stocks (for examples, see the SEC’s advice on asset allocation).
Stocks have the potential to be very volatile, meaning they can rise or fall dramatically in a short amount of time, reflecting fluctuating market value. By diversifying your stock portfolio across different companies and industries, you can lower your risk. While this decreases the opportunity for a huge windfall with the rise of a single stock or industry, it’s a smart strategy if stability is your priority.
Bonds are more stable than stocks, since your return doesn’t fluctuate with the market: you know exactly how much the borrowing company or government owes you. That’s why bonds qualify as fixed-income securities. The only risk is if the borrower defaults before it has to pay up, as can happen with an unstable government or similar institution. The bigger this risk, the bigger the interest rate you’ll gain, with the most stable bonds (like U.S. Treasury bonds) offering the lowest rates. According to traditional investment logic, bonds become increasingly important in your portfolio as you approach retirement.
Benefits of stocks and bonds
Stocks and bonds are the traditional staples of investment portfolios. One reason is that they allow you balance between the growth and risk you’re comfortable with. More precisely, they allow an individual investor to pick companies, borrowers, and strategies that fit their particular risk tolerance. While stocks have rapid growth potential and bonds are relatively secure, the greatest benefit comes from finding the perfect balance for your retirement plan.
Risks of stocks and bonds
Stocks are particularly risky, as they do not guarantee income and potentially could lose all their value. Diversifying your stocks can help, but you’ll still be vulnerable to a market-wide decrease.
Certain bonds are riskier than others, but they’re usually a relatively stable bet. Be wary of bonds with high yields because they usually have a higher risk of default. These types of bonds have come to be known as “junk bonds.” Though most bonds aren’t as liquid (i.e., easily exchangeable for cash) as stocks, treasury bonds are usually extremely liquid, thanks to a willing and active secondary market.
Stocks and bonds considerations
Municipal bonds (bonds issued by local governments) may be exempt from federal, state, and local taxes. Though you can choose to invest in particular stocks and bonds, you may want to look into mutual funds, which automatically spread your money across a collection of stocks, bonds, and other investments. Consider scheduling a retirement income checkup to determine what risk tolerance fits your own goals for retirement.