WHY YOU NEED BOTH EQUITIES AND BONDS IN YOUR PORTFOLIO
Every investment involves some amount of risk taking, and as a rational investor, your aim should be to maximise your returns as much as possible, to obtain the best compensation for whatever level of risk you decide to take. When it comes to earning interest, your savings can either go to the bank or building society or to bonds and gilts. Bonds and bank/building society deposits compete for the funds of individuals, and thus usually have the same trend (rise or fall) in interest rates and yield. Concerning yields, the longer the maturity, the higher the expected compensation or yield. In order to comprehend the need for both equities and bonds in your portfolio, you must first fathom the relationship between interest rates, inflation, strength of currency and the well-being of an economy.
When one invests in a share/equity, what has fundamentally happened is that an ownership has been purchased in the company that is being considered. This means that one can make decisions and also share in the profits of the firm. Profits are distributed in the form of dividends, and it is the directors of the firm that decide how much dividend they want to pay out of profits. In fact, where all profits are reserved for growth, no dividends at all are paid sometimes, a practice very typical of small and new companies. It must also be noted that the money that is invested, unlike an investment in bonds, cannot be redeemed. One good benefit of equities, though, is that it protects investors from the sting of inflation. This is because firms tend to make more profits and their shares tend to pick up value, as inflation rises. This shelter from inflation is nevertheless denied bond investors, whose real yields, will be very much impinged upon by a rise in inflation.
It is rewarding to be aware of the inverse relationship that exists between the price of bonds and interest rates. When interest rates rise, the price of bonds fall and vice versa. This is because as mentioned earlier, bank and building society deposits, vie for the funds of individuals. When interest rates rise, bank and building society deposits become more competitive, and it is necessary for the price of bonds to fall to compensate for the lower yields being paid. Conversely if interest rates fall, the price of bonds will rise, so that investors pay for the higher yields they can earn.
A booming economy normally has businesses as well as individuals chasing a lot of money to invest in production and to spend on day to day activities. The forces of demand and supply kick in, and hence increases the price of borrowing, which is interest rate. A boom also tends to trigger inflation, and a fall in currency, which benefits equity holders, but affects bond holders negatively as afore-said – a rise in interest rates leads to a fall in price of bond, and the increase in inflation devours the real value of the yield. The opposite of this combination of effects can be anticipated during a recession. Since the future is fairly uncertain, and one cannot accurately predict whether there will be a boom or recession, an investment that encompasses both equities and bonds stands to gain whether there is economic recession or boom.
The bottom line is that a mix of equities and bonds in a portfolio allows the investor to even the downs of one security with the ups of the other, whether there is a boom or recession. It is akin to the benefits enjoyed by a man I know who goes to Africa during the winter months, because the weather there at that time of the year, is really sunny and dry. When the rainy season starts in June/July, he will be nowhere to be found! Where do you think he will be? Back in England to have his share of the brightness of summer! In effect the access to England and Africa, like having a mix of bonds and equities, does not make him experience the torture of bad weather.