There are all sorts of things you can invest in. But there are two essential building blocks — shares and bonds. So what exactly are they? Why are they worth investing in? And what are the risks entailed?
You’ve probably noticed there’s a tendency to make investing complicated. Of course, you can choose to make it complicated if you want to, but, at its heart, investing is actually very simple.
As an investor, what you’re doing is sharing in the proceeds of human enterprise, or capitalism. And you do this by either buying stakes in companies, known as shares, or lending money to those businesses (or to governments) in the form of bonds.
What is a share?
Shares, often referred to as stocks or equities, represents ownership in a company. When you own a share, you essentially own a small piece of that company.
Companies issue shares to raise capital and allow investors to buy a stake in their business. Owning shares means you have the potential to receive a portion of the company’s profits, known as dividends, and you may also benefit from any increase in the company’s value over time.
The benefits and risks in owning shares
Share ownership comes with a number of benefits. When companies perform well, the share price generally increases. Some companies distribute a portion of their profits to shareholders in the form of dividends. Those two things combined — capital gains and dividend income — can generate significant profits. Historically, shares have delivered good returns to patient investors.
As a shareholder, you also have a say in the company’s decisions. You can vote on important matters at shareholder meetings and have a voice in the company’s governance.
It’s important to remember though, that investing in shares (and indeed in anything else) involves risk, and it’s possible to lose money. Share prices go up and down, and the value of your shares will inevitably fluctuate. If a company you’ve invested in performs poorly or faces financial difficulties, the value of its shares will almost always fall, and you may receive fewer dividends, or none at all.
Broader economic and market conditions can also affect share prices generally. Factors like economic downturns or market crashes can lead to significant losses.
What is a bond?
A bond is a type of investment where you lend your money to a company or government in exchange for periodic interest payments and the promise that they will return your initial investment, known as the principal, when the bond matures, which is a specified date in the future.
Bonds are essentially IOUs, where the issuer borrows money from bondholders and agrees to pay it back with interest over time. Bonds are commonly used by organisations to raise capital for various purposes.
The benefits and risks in owning bonds
The main benefit of investing in bonds is that they are considered a relatively safe investment compared to shares because they generally provide a predictable income stream and return of principal. Bonds offer an effective way to preserve capital and therefore act as a stabilising force in a portfolio.
It’s important to remember, though, that bonds also have limitations. They may not provide the same potential for high returns as stocks, and their value can still fluctuate in response to changes in interest rates. As with shares, it’s possible to lose money. Companies do occasionally default on bonds, and, although it’s very rare, governments can do so as well.
Most investors need both shares and bonds
Almost all investors over the age of 40 own a combination of shares and bonds.
Because shares have traditionally provided much higher returns than bonds, investors who primarily want their money to grow should invest mainly in shares. Because bonds are less risky and volatile, very cautious investors and those who mainly want to preserve their wealth, especially older people, will want to own a higher proportion of bonds.
By having both shares and bonds, you reduce the overall risk of your portfolio because they often react differently to economic conditions and market fluctuations. When one performs poorly, the other may perform better, helping to balance out your portfolio’s performance.
How much of each should you own?
Every investor is different. We all have different circumstances, needs and goals, and we all have different attitudes to risk. One of the most important reasons for using a financial planner is to work out how much risk you should be taking — in other words, how much to invest in shares and how much in bonds.
It all builds down to what we call your risk capacity. Essentially, you need to answer three questions:
- How much risk do you need to take?
- How much risk can you afford to take?
- How much risk do you feel comfortable taking?
Based on the answers to those questions, your financial planner will then recommend a portfolio that reflects your personal risk capacity.
In theory, it’s possible to work out your risk capacity on your own. But risk capacity and portfolio construction are complex subjects, and it’s far better to seek the help of a professional who understands all of the issues involved, and particularly the part that emotional and behavioural factors play in investment decision-making.
Make sure you get it right
Finding the right mix between shares and bonds is crucially important. Get it right, and you set yourself up for achieving your financial goals. Get it wrong, and you could end up in a real mess. Either you will realise too late that you don’t have enough money to last you for the rest of your life because you didn’t take more risk; or you will take too much risk and end up selling your shares at the wrong time and sabotaging your own portfolio.
In the long run, having a sound financial plan really does pay off.
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