Asset Allocation: Stocks and Bonds

OK, before I talk about diversification, I should probably talk about what we will diversify first, so here is the big stocks and bonds discussion. This is gonna be a long , so more after the break..

Let’s start with bonds. Bonds are essentially a loan where you “lend” the money to the government or business that is issuing the bonds for a set period of time at a specific interest rate. The date that you will be paid back is the maturity date, and interest will be paid during the life of the bond on a regular basis. The value of the bond (the money that you will receive back at the maturity date) is the face value of the bond. The interest rate on a bond is based on the time to maturity and the bond rating. Long-term bonds generally pay a higher interest rate because of the increased risk in holding a long-term investment, although economic conditions can sometimes cause shorter-term bonds to pay back a higher interest rate, in what is known as an inverted yield curve. The bond rating is to evaluate the ability of the lending entity to repay the principle. Bond rating agencies, such as Standard and Poors, rate the bonds either investment grade, which indicate a better ability to repay the bond principle and a lower risk, or junk, which have a higher risk of default. Investment grades by S&P are AAA, AA, A, and BBB, with junk bond grades of BB, B, CCC, CC, C, and D. The lower the grade, the greater risk of default by the bond issuer, and the higher interest rate that the bond issuer must provide to compensate for the greater risk.

Bonds can also change value, but this is essentially if they are bought and sold in the secondary market, where bonds are traded before their maturity date. Bond prices move in the opposite direction of interest rates; that is, if the interest rate is going up, bond prices go down, and if interest rates go down, bond prices go up. I don’t know that much on this topic, I’ll just stop talking… Fidelity has some information on bond prices here.

Now, for stocks… Essentially, stock is ownership in a company. Stocks, or shares, or equity, can be divided into different groups for descriptive purposes. One way is to look at the value of the company, or its market capitalization. These groups are the large, middle (mid), or small capitalization(cap). Large cap stocks are those companies that are over $10 billin in value. (Some refer to companies over $200 billion as mega caps.) Mid caps are between $1 or $2 billion to $10 billion in market value. Small caps are under $1 billion. (Micro cap is sometimes described at $50 to $300 million, while nano cap is under $50 million.)

Another method of describing stocks is as value or growth stocks. Value stocks are those that one believes is undervalued by the market. For example, The markets may react to bad news about a company, and even though the company still has strong fundamentals, the stock drops. Growth stocks are those that one beleives is going to grow faster than the market. Technology stocks like Google are growth stocks.

For investors in the U.S., stocks are also divided into domestic and interenational stocks, and international stocks can also be divided into developed or emerging markets, and further grouped by market cap or whether it is a growth or value stock. Fianlly, stocks can also be grouped into sector catagories, such as financial, utilities, or technology.

Generally, small and mid cap stocks are riskier. For example, who do you think has a higher risk of going bankrupt: Joe’s House O’ Plants or Home Depot? Large caps generally have more consistent earnings, pay a dividend, and are less risky. But small caps have a larger growth potential. Imagine owning the next Microsoft before it becomes one of the largest companies in the world. Because smaller cap stocks are riskier, over the long run they generally have a higher return than large cap stocks. So why not just buy all small cap stocks? Because it is only over long time periods that small caps do better. In the short term, small cap prices are more volatile, and an investor could lose more of their investment than if they were invested in large caps.

Mutual funds are a way of holding many different stocks, bonds, or both. Rather than dealing with one company and essentially “putting all your eggs in one basket,” a mutual fund holds many different stocks or bonds, so if one company does poorly, you will not lose most or all of your investment. Mutual funds can be targeted for specific goals, such as mid cap value stocks, short-term government bonds, or international energy growth stocks. They can also be used to match various indexes, like the S&P 500, in what is known as an index fund. Mutual fund companies charge a fee to manage the fund, the expense ratio, which lowers to total return of the fund. Funds are priced and traded at the end of the day, after the final price of all the fund’s components are determined.

Another way to own a basket of securities is through an exchange traded fund or ETF. WIth an ETF, you get the diversification of a mutual fund, but they are traded during the day like stocks. ETF also have an expense ratio, although generally lower than mutual funds, but you also have to pay a brokerage fee to trade an ETF.

Finally, others sometimes discuss different asset classes such as real estate, or bullion (gold, silver, platinum), but you can participate in these classes through funds or ETFs, such as REITs (real estate investment trust) or the gold and silver ETFs, for physical gold and silver. At this point, when discussing asset allocation, we’ll stick with what we have here.

Update: I almost forgot another asset class: Cash. This does not necessarily mean physical bills, but rather something a little more liquid than stocks or bonds, like a savings or checking account, where you have relatively easy access to your money.  This would also include a money market account.  These types of accounts generally do not earn much interest, although there seems to be a proliferation of high yielding (5%+) accounts on the internet lately.  Also, these accounts do not drop in value (except for what you spend) and are used mainly for capital preservation.  If someone is very unsure about the markets, or wants to avoid risk, this is where they would park their money.