How To Grow Your Money With Stocks And Bonds
Stocks and bonds have been the building blocks of investment portfolios for centuries. And throughout the years, many investors have grown their wealth and achieved their financial goals by purchasing them.
However, to profit from them, you need to understand what stocks and bonds are and how they work together to help you grow your wealth.
Introduction to stocks
A stock is an asset that represents a portion of ownership in a company. When you buy a company’s stock, you have a measure of ownership that corresponds to the number of shares you buy.
Shareholders make money in two ways: through dividend and capital gains. A dividend is a portion of a company’s earnings that they distribute to shareholders at the end of the quarter. Capital gains occur when shareholders sell their shares for a price higher than they bought it.
Benefits of stocks
There are two main reasons why stocks are so popular for wealth building.
First, stocks provide high returns to investors. Compared to bonds (and other investment options), the returns on stocks are massive. For example, the S&P 500 Index (a representative of the US stock market) has grown by 109% over the last 5 years.
Second, with stocks, investors enjoy compound interest. The money you invest earns interest and you can reinvest the interest so it also yields more money.
Disadvantages of stocks
However, just as stocks provide high returns, they are also prone to risk. Stocks are volatile and their prices can swing up and down significantly over a short term. For example, the S&P 500 Index fell from $3,380.16 on January 10, 2020 to $2,304.92 on March 16, 2020, a 31.8% drop in value in just five weeks. (Of course, all of this loss was recovered in just a few months, but this systemic risk is nonetheless a part of investing.)
Secondly, with stocks, there is no guarantee that you won’t lose your investment. A stock may continue to fall until you lose a large portion of your principle, especially if you are only in the market for a short time. This is why most financial advisors instruct investors to have a long-term mentality when approaching the market.
Introduction to bonds
A bond is an instrument of indebtedness that companies and governments use to raise money. The bond issuer borrows money from the bond holder, who expects to be repaid with interest (the coupon rate) over a defined period of time.
Bond holders make money in two ways: through bi-annual coupon payments and capital appreciation (by selling the bond for a price higher than its face value).
Benefit of bonds
Unlike stocks, bonds are low-risk assets. While the stock market experienced double-figure yearly volatility 39 times between 1982 and 2018, the bond market experienced it only twice.
Similarly, unlike stocks where there is no guarantee for your initial investment, bond issuers have a duty to repay your initial investment when the bond matures.
Furthermore, when companies are in trouble, they first repay their bond holders before the stockholders.
Disadvantages of bonds
However, bonds offer lower returns compared to stocks.
The yield on a 5-year US treasury bond, for example, is just 1.24% and that of a 50-year UAE treasury bond is 2.7%.
A diversified portfolio of stocks and bonds
Stocks and bonds have their advantages and disadvantages; however, when combined together, they are the best building blocks of wealth. How so?
When you hold a portfolio of stocks and bonds, the presence of bonds reduces the risk of the portfolio compared to an all-stock portfolio.
On the other hand, when you hold a portfolio of stocks and bonds, your returns are higher compared to an all-bond portfolio.
Also, most of the time, the stock and bond markets are negatively correlated which means when one is falling, the other is rising and providing a cushion. In an all-stock or all-bond portfolio, no such cushion is available.
This is why successful investors always find a way to combine stocks and bonds in a way that aligns with their investment goals.
Conclusion
If you are ready to grow your wealth through investing, it is best to do so in a diversified portfolio of stocks and bonds.
A platform like Sarwa will use the nobel-prize winning Modern Portfolio Theory to help you create an optimal portfolio of stocks and bonds that will best help you achieve your financial goals.