We have been advised to have a well-balanced diet in order to grow and stay healthy. Did you know your wealth needs it too? For your portfolio to thrive, it needs to have a variety of food too, just like we do.
Here’s what you should be feeding your portfolio:
1) Rice – This is cash. It is not particularly nutritious or beneficial in growing your wealth, but it is a staple needed for its sustenance.
2) Fried chicken – This is equity. Eating this makes you feel good and it might help your porfolio grow bigger, but it also puts your portfolio at high risk of health problems. (Read more about equity here.)
3) Vegetables – These are bonds. They are unexciting, but essential and nourishing. It grows your wealth steadily and helps offset some of the unhealthy effects from the fried chicken. (Read more about bonds here.)
Each has its distinct role and is important in its own right. However, the importance of bonds has been overlooked by many and here are 2 main reasons why you should not do the same:
It serves as a good and safe store of value for future expected cash-flow needs
In most cases, bonds would pay a fixed interest payment to you at regular intervals. It is a predictable and steady source of income, with considerably little risk.
It preserves your principal value and generates a dependable cash flow from the interest payments. This characteristic makes bonds useful for saving and long-term planning.
More importantly, it helps to diversify your portfolio risk
While bonds do not help much in generating extraordinary returns for the portfolio, they are effective cushions (provided they are of good quality) and can help you to absorb some risk from all the fried chicken.
Equity and bond prices tend to be inversely correlated e.g. when the stock market is doing poorly, bond prices tend to go up. Hence, having bonds in a portfolio will help you to reduce portfolio risk and losses.
To illustrate, in the 1987 stock market crash, when U.S. equity markets plunged more than 20% in a day, U.S. treasury bonds performed considerably well. They became the sanctuary for many investors.
The diversification effect between equities and bonds can help to even out volatility swings in the market, especially during flights from equities.
It is wise not to neglect the critical role bonds play in your portfolio. Furthermore, bonds come in different types, such as government bonds and municipal bonds etc. It is important to be discerning when it comes to which to invest in, so as to choose the bonds most palatable to your portfolio.
Now that you know the importance of bonds, make sure to have some in your investment diet!
