How to allocate your investments between stocks and bonds
Every investor tries to build a portfolio that maximises returns while minimising risks. This requires finding the correct balance between investing in stocks and bonds. But stock prices are inherently volatile and deploying your investible funds into the stock market can lead to sharp fluctuations in the market value of your portfolio.
Bonds, on the other hand, are less risky. They provide a steady stream of returns, but there is little scope to see a growth in the value of your investment.
The most prudent approach is to build a balanced portfolio that includes both stocks and bonds. Stocks have the potential to provide capital appreciation while bonds will give your portfolio stability.
How should you allocate your investments?
If you are looking for safety, you should restrict the amount that you allocate to stocks. An investor who deploys all his money into the stock market may see a fall of 50% or even more in the value of the investment that has been made.
It is possible to reduce the level of risk by buying bonds. There are four broad risk categories that an investor can fall into:
- Highly aggressive – an investor who buys only stocks assumes a high degree of risk. This strategy is recommended only for young people who will not need to access their investments in the short or medium term.
In fact, it is advisable to have a minimum time horizon of 10 to 15 years. If you need to liquidate your portfolio earlier than this, you could see a depletion in your principal amount.
- Aggressive – an investor in this category does not hold just stocks. About 20% of the portfolio is diverted to risk-free bonds. It is fairly certain that at least this portion of the investment will not decrease in value.
But along with a reduction in the level of risk, there is also a drop in the potential for an increase in the value of your portfolio.
- A balanced approach – those looking for a greater degree of security would do well to restrict their investments in stocks to only 60% of their portfolio. With the remaining 40% in bonds, the best that investors can hope for are an average level of returns.
- Conservative investors – A person who is past the retirement age or who does not have any source of income other than the returns from an investment portfolio would find this option attractive. People who are very conservative could even allocate 80% of their investible resources to bonds.
Should your investment allocation change with age?
There is a rule of thumb that you can follow to determine the manner in which to split your investments between bonds and stocks. Subtract your age from 100 and the figure that you get should be the percentage of your investment that goes into stocks.
A 30-year-old investor would apportion 70% (100-30) of the total investment to stocks. The remaining amount would go into bonds. Similarly, a 40-year-old would allocate 60% to stocks.
But with increased longevity, it may be preferable to deduct your age from a figure of 110 instead of 100. This would lead to a greater percentage of your investment going into stocks.
Although this method can be used to get a rough idea about how to allocate your investments, it should not be implemented without considering your individual circumstances. For example, a retiree aged 75 who gets a pension that is adequate to meet regular expenditure may wish to allocate 80% of savings to stocks.
Is an investment in bonds risk-free?
Unfortunately, bonds or fixed-income securities also carry a certain degree of risk. Last year, Singapore-based companies like Swiber Holdings and Rickmers Maritime failed to meet coupon payments. If a firm that has issued bonds faces financial difficulties, your money may be at risk.
Government bonds are risk-free and you can be assured that your investment will be absolutely safe. Of course, the downside is that you will earn a lower rate of interest on sovereign bonds.
There is another scenario in which bonds carry the risk of depleting in value. If interest rates rise, the market will prefer to buy those bonds which are being issued at higher coupons. This will drive the price of existing bonds down.
But of course, you can avoid this situation by holding the bonds that you have bought till their maturity date and redeeming them from the issuer.
Should your entire investment portfolio be in stocks and bonds?
Some investors would like to diversify and buy gold or real estate as well. But for most people, stocks and bonds are adequate.
It is also important to keep a certain amount of cash, possibly in a savings bank account or any other investment that is absolutely safe and can be accessed at short notice.
The sum set aside in this manner should be enough to provide you with living expenses for about six months. This can take care of any unforeseen circumstances that may arise.
The reason that you should keep some money in this manner is to ensure that you do not need to sell any part of your investment portfolio in the event of an emergency.