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Turmoil in the stock market can put investors on edge. After witnessing recent market turbulence, specifically related to equity international markets, investors are aware that stock prices can plunge as easily as they can soar. However, many investors still believe that in the long run, stocks outperform other asset classes such as bonds.
By definition, a stock is a stake of ownership in a company that is sold off in exchange for cash. A stock is a security in a particular company and may be generally also referred to as equity or a share. By buying a stock in a company, investors would be buying claims to a company’s earnings and assets.
Contrarily, a bond is a fixed income security that represents debt obligations and is therefore regarded to be a form of borrowing. While stocks are a stake of ownership in a company, a bond is a debt obligation that a company enters into with the investor on the agreement that the company will ultimately repay in full the money lent together with the issuance of regular interest payments.
In an attempt to construct an optimum investment portfolio, an investor might face the challenge as to what portion of his/her capital should be allocated to stocks or bonds respectively. In line with an early study conducted by a famous finance Professor William F. Sharpe, portfolios should be diversified among asset classes and investors should consider how the risk and return characteristics of one type of asset class relate to those of other asset classes within an investment portfolio.
If an investor is interested in constructing an investment portfolio comprising of stocks and bonds, what the investor initially really needs to do is to compare the different types of asset classes in terms of returns, risk, together with the degree of correlation between them.
One particular approach which may facilitate the above presented challenge is to analyse particular asset classes in terms of risk-adjusted return, otherwise known as the Sharpe ratio. This ratio is a mathematical formula designed to assist investors in understanding the return of a particular investment in comparison to its associated risk. The higher the value of the Sharpe ratio, the more an investor is likely to be rewarded for taking on additional risk.
As a fundamental concept of modern portfolio theory, the latter has proved to be an influential approach to investing. This theory holds that by investing in a range of asset classes, investors can maximize return for the risk they are willing to bear. Different asset classes react differently to world economic events. Subsequently, the combination of different securities have the capability of reducing the overall risk within an investment portfolio.
In a robust attempt to make a correct and informative investment decision, instead of solely using one statistical measure, an investor should also consider how much risk he/she is willing to take. For instance, investors with a shorter-term goal such as paying for a child’s education would take on less risk in comparison to a young investor who has just started saving with the intention of building an investment portfolio.
Evidently, bonds may reduce the investor’s long term returns. However, through the stabilising effects of bonds, investors will be less willing to sell off bonds if there would be a sharp decline in the stock market. In other words, fixed income investments within an investment portfolio provides investors with a sufficient degree of power to remain in the market if a sudden drop in equities occurs.
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