Pros and cons of diversifying into stocks and bonds

Like you, I have definitely considered the following question: stocks or bonds? Which option is best for diversification?

Investing may be the best way to grow your wealth, secure your financial future and plan for your retirement. But with so many investment options to choose from, it can be difficult to determine which wealth-building engine is best for you in the market.

I’ll explore the pros and cons of investing in stocks or bonds, one of the most common ways to diversify your real estate portfolio. However, I recommend that you consult your financial advisor before making any of these investments.

stock

Stocks or equity are securities that represent partial ownership of the issuing company. Stocks represent ownership units of a company or financial asset owned by investors, who exchange capital for the units. When you buy stock, you become a shareholder and own a small share of the company.

Stocks, like bonds and real estate, can provide strong long-term returns but can also be extremely volatile in the short term. Here are some pros and cons to consider:

Advantages of stocks

1. higher returns
   • Standard & Poor’s Average return rate of 500 Exceed It has been around 10.2% over the past decade, just below the long-term historical average of 10.7% since the benchmark index was launched 65 years ago.
   • According to a study by New York University, the historical return on stocks has been between 8% and 10% since 1928.
2. dividend-paying stocks
   • Dividends represent payments made by a company to shareholders from income generated by the business, and are usually paid quarterly.
   • When dividends are reinvested, they can significantly increase total returns over time, making dividend stocks an attractive choice for older investors approaching retirement and younger investors just starting to build a financial foundation.

Disadvantages of stocks

1. higher risk
   • You guessed it: higher potential reward = higher risk.
   • Generally speaking, stocks are riskier than bonds because they do not provide investors with guaranteed returns, whereas bonds provide fairly reliable returns through face payments.
   • Unlike interest payments on Treasury bonds, dividends are not guaranteed. Companies can cut or significantly cut their dividends at any time, a risk that became a reality in 2020, with 68 of the roughly 380 dividend-paying companies in the S&P 500 suspending or reducing their payouts.

bonds

Governments and businesses issue bonds when they want to raise money. By purchasing a bond, you provide a loan to the issuer, and they agree to repay you the face value of the loan on a specific date, paying you interest at regular intervals along the way, usually twice a year.

Once the bond matures, the bond issuer returns the investors’ money. Fixed income is a term often used to describe bonds because your investment earns fixed payments over the life of the bond.

Advantages of Bonds

1. low risk
   • Bonds are backed by the U.S. Treasury, which never defaults on its debt, which means you’ll almost certainly receive interest on time and get your principal back at the end of ownership. Regular income can be helpful for investors who need funds for daily expenses. Or, if you don’t need the money right now, you can reinvest your earnings.
2. Fixed income is sometimes duty free
   • If you purchase a municipal bond from a local, city, or state government, you generally do not have to pay federal income taxes on the income. Depending on where you live, you may also avoid local and state income taxes. Income from federal bonds is generally exempt from local and state income taxes, but is still taxed at the federal level.

Disadvantages of Bonds

1. Value falls when interest rates rise
   • If interest rates rise, the value will fall. Someone will not be willing to pay $1,000 for a bond that pays 4% when they can buy a new bond that pays 5%. Conversely, if interest rates fall, the value of your bond may increase. The effect of changes in interest rates on a bond’s value is also known as interest rate or market risk.
2. Yields may not keep up with inflation
   • The risk is that price increases reduce the value of the fixed income you receive from the bond. Even if inflation does not rise significantly, the compounding effect of inflation on prices can be significant over 20 to 30 years.
3. Some bonds can be redeemed early
   • You may not think of prepayment as a risk, but that’s exactly what “redemption risk” describes. Typically, this happens when interest rates fall. Although a lower interest rate may increase the value of your bond, the issuer is not buying the bond from you; Just pay off your debt early. Bond issuers may turn around and issue new bonds at lower interest rates to save money. But now that you’re strapped for cash, you probably can’t find an equally safe way to earn the same amount of interest.

Diversify your investment portfolio with bonds and stocks

The short answer to the “stocks or bonds” question is to include both in your portfolio. Stocks and bonds are much more passive in nature than any real estate investment you may pursue. Having a healthy share of each investment engine can only have a positive impact on your ability to weather storms in a given market and mitigate a lot of risk through diversification.

Personally, I don’t hold any bonds and my bond investment ratio is always less than 5%. I certainly have a larger equity position compared to real estate and stocks, but that’s not always the case! Currently, nearly 95% of my investments are in real estate and only about 5% in stocks. Before I became a real estate investor, my investments were close to 90% stocks and 10% bonds.

These splits will continue to fluctuate as I use the stock market to grow capital, save for my next down payment, and my recent holdings have increased since the ultimate goal is to convert this into real estate capital. Over time, I will definitely reevaluate my risk tolerance and may lean toward more passive, safer sources of income, such as issuing high-dividend stocks and bonds.

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Notes on BiggerPockets: These are the opinions written by the author and do not necessarily represent the views of BiggerPockets.