An investment portfolio typically contains some bonds and cash or cash equivalents, such as certificates of deposit (CDs) or money market mutual funds. However, everyone's investment strategy is different, as investment elections depend on a number of different factors such as age, investing time horizon and overall financial situation.
Cash equivalent securities provide the benefit of principal protection. Cash securities are considered safe havens for your money because they experience little or no price fluctuation, and some brokerage CDs are even federally insured. Bonds are also considered safer than stocks, though not as safe as a CD. Bond prices can fluctuate and bond holders can lose principal if the bond issuer defaults on the debt. Nevertheless, bonds expose you to less risk than stocks because bond holders claims on a failed corporation are settled ahead of stock holders claims. Therefore, while not risk-free, most people regard both bonds and cash securities as conservative investments.
History suggests that people with longer investment time horizons can afford to take more risks with their investments. This is because stocks have outperformed bonds and cash equivalents over periods of 10 years or more. If your portfolio drops in value, you have longer to recover your losses if you leave your money in the market for 10 or 20 years as opposed to one or two. Therefore, if you plan to withdraw your money from the market within the next few years, you may want to consider primarily investing in bonds and cash because to reduce the chances of losing principal. If you plan to leave your money in the market for 10 years or more, then you could opt to invest the vast majority of your assets into riskier securities that offer more growth potential.
Retired people often need to generate supplemental income to cover their day-to-day expenses. This can be done by investing the majority of your assets in bonds and using the interest payments as supplemental income. If you do not yet need the income, but you plan to retire within a few years, you could arrange your portfolio so you have mostly cash assets that are unlikely to drop in value. When you retire, you can replace the cash securities with income-generating bonds. If you do not plan to retire for many years, then you should consider investing heavily in stocks because interest payments on bonds and CDs do not always keep pace with inflation. Therefore, you expose yourself to inflation risk and a loss of spending power if you invest too conservatively for too long.
Many young investors opt to invest 40 percent or less of their assets in bonds and cash while many retired people invest 60 percent or more in these securities. However, while some bonds, like cash securities expose you to minimal levels of risk, others expose you to risk levels more comparable with stocks. So-called junk bonds are high-yield, high-risk bonds that experience the kind of price fluctuations that you expect to see with stocks. Before investing heavily in bonds, make sure you understand the difference between low-risk federal bonds and high-risk bonds, such as some mortgage-backed securities and other derivatives. If you don't do your homework, you may find that your portfolio exposes you to an unnecessarily high level of risk.
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