“Buy all, I want them all,” an ecstatic Monty told his broker over the phone. On the advice of a ‘fin-fluencer,’ he invested all of his pocket money in pharma stocks, believing that the sector would rally post-covid. Observing this incident brought back memories of his time in the US for Mr. Sethi, Monty’s father. Sethi’s stock portfolio was entirely made up of tech companies. In the late 1990s, the tech sector was booming, and Sethi’s portfolio was performing exceptionally well. However, when the dot-com bubble burst in 2000, many tech stocks plummeted, and Sethi suffered significant losses. After this experience, Sethi realized the importance of diversifying his portfolio to reduce risk. He allocated a portion of his portfolio to bonds, which are considered less risky than stocks and have a low correlation with them. Fast forward to 2008, the global financial crisis hit and stock markets around the world plummeted. Despite this, Sethi’s portfolio was relatively stable because the bonds in his portfolio provided a cushion against the losses in the stock market. The notion behind this was when stock markets are in turmoil, investors often flock to safer assets like bonds. This increased demand for bonds drives up their prices and leads to higher returns for bondholders. Mr. Sethi smiled and walked away, thinking it was time for Monty to learn his lesson.
Holding both stocks and bonds can lower a portfolio’s overall risk because bonds and stocks have different risk and return characteristics. Bonds typically hold their value better when stocks are performing poorly, and vice versa. Compared to stocks, they usually have lower default risk which can lessen the danger of permanent capital loss. The efficiency of bonds in lowering portfolio risk will depend on the specific bonds and stocks held in the portfolio, as well as market conditions and other factors.
Bonds can help protect capital when they are a part of a portfolio since they generate a consistent income stream even in volatile or difficult market situations. This helps lessen the risk of losses from other portfolio investments, like equities, which may see significant value reductions. Bonds also often exhibit lower volatility than stocks and act as a buffer against the dangers related to equities investments.
Due to the fact that investors receive a fixed income stream in exchange for a debt to a company or government, bonds are thought to be less volatile than stocks. This means that the return on a bond is predetermined and does not fluctuate with market conditions like stock prices do. When interest rates rise, bond prices tend to decline, but this decline is more gradual than the sharp fluctuations in stock prices that can occur during market downturns.
Bonds help in revenue generation in a portfolio by providing a steady stream of fixed income. The income on a bond is predetermined in the form of coupon payments and paid at regular intervals, providing it a consistent source of earnings for the investor. This feature also helps to provide a steady source of income, even during market volatility, making it a useful tool in the portfolio. By providing a steady stream of income, bonds can help to meet an investor’s financial goals and provide stability in their portfolio.
In a portfolio when interest rates are falling, bonds can contribute to capital growth due to the inverse relationship between bond price and yields. Bondholders benefit from capital appreciation when interest rates decline because existing bonds with higher yields are worth more on the market. This is because newly issued bonds with lower yields become less attractive to investors, driving up the price of existing bonds. As a result, the bondholder can sell their bonds at a higher price, realizing capital appreciation. Including bonds in a portfolio can provide the potential for capital appreciation, helping to diversify investment strategies and preserve capital over the long term.
In conclusion, effective and balanced portfolio diversification is key to maximizing returns and minimizing risks in investing. This is achieved by spreading investments across different asset classes, sectors, geographies and market capitalizations. A diversified portfolio not only helps to manage investment risk but also provides a better opportunity for long-term growth. Bonds, as a fixed-income security, can help stabilize the portfolio by providing steady, predictable income. To achieve a truly diversified and balanced portfolio, it is recommended to consider a range of bond types and maturities, alongside equities and regularly review and adjust the portfolio as market conditions change.