We invest to increase wealth and to have the means for reaching our financial goals like a comfortable retirement, travel, or providing an education for our children. Investing means putting money to work in order to make more money by purchasing assets whose value is expected to increase and provide a nice return upon being sold. Investing in stocks (and thus owning a small fraction of a company) entitles the owner to a portion of the company’s profits through dividends, share buybacks or reinvestment that increases the company’s and stock’s value.
The stock market has historically had volatile returns in periods of 5 years or less, but consistently high returns over decades-long time frames. If you’re under 40 and prepared to invest and tolerate the risk of short-term declines in high long-run returns, is there any need for adding debt investments to your portfolio, or should you be in all stocks?
Equity investments offer high risk and rewards. A company’s growth, increased sales, greater market share, or product/service improvement typically translates to higher stock prices or income to investors through dividends. Any individual company can prosper or falter, but buying a broad swath of companies (such as the DJIA or S&P 500 indices) has historically ensured high returns over long holding periods. It can, however, be very tough psychologically to hold on to an individual investment that is doing poorly, or to sell nothing when your entire portfolio has suffered steep declines.
In 2008, the DJIA fell by 33.8%, and the S&P 500 decreased by 36.55%. Many people could not watch the events unfolding without selling their shares at a loss. Including debt-based investments in your portfolio can provide a bumper for when the stock market gets rough by allowing for smoother performance, lower volatility, and thus less stress and potentially ill-timed decisions to sell investments.
Debt investments include government, corporate, and municipal bonds, as well as real estate investments, peer-to-peer lending, and personal loans. With a debt-based investment, rather than ownership of an asset or company, you lend money to an individual, corporation, or government entity and receive a fixed income in return. Such investments typically offer a lower but more consistent return than stocks.
There is some risk that the entity you’ve loaned money to won’t be able to repay the debt, so it is important to work with proven originators and choose investments wisely. Some things to consider when choosing a debt investment are the collateral liquidity, loan-to-value ratio, and seniority. Certain loans (such as real estate investments) have collateral (the real estate itself) that can be sold (liquidated) to recoup the investment in the case of default. The loan-to-value ratio (LTV) is an expression of the loan to total asset value and is used to analyze loan risk. A higher LTV means a riskier loan. First-lien lenders on a senior secured loan will be repaid first in the event of a default or borrower bankruptcy, followed by junior lenders.
Debt investments are a different asset class from equity investments, and it’s recommended that both classes be in your portfolio for better diversification. At the crux of the matter is that the two asset classes often move in different directions, with one zigging when the other zags, ensuring that poor performance in any one area doesn’t lead to a significant decrease of the whole portfolio.
High investment returns enable a quicker path to meeting financial goals, and a larger ultimate net worth. While stocks historically provide high long-term returns (higher than most debt-based investments such as bonds), their declines can be steep in any one year. Watching your portfolio decline massively can be stressful for an investor, and historically many have sold at a loss during such times.
Debt-based investments often perform differently than stocks, increasing in the years of large stock declines. Because diversifying by combining equities with debt-based investments decreases the probability of large portfolio declines, it’s recommended that investors hold both. An individual’s exact allocation is dependent on goals, risk preferences, and investment time horizon, but even younger investors are encouraged to consider holding both equities and debt-based investments.
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