Asset Classes: Stocks and Bonds

The world is made up of two types of people: those who break up humanity into two types, and those who don’t. And the world of retirement investments is made up of two asset classes: equity (aka, stocks) and fixed income (aka, bonds).

OK. That last sentence is a bit of an overstatement (which I’ll come back to in a minute). But mostly it’s stocks, of one kind or another, or bonds, of one kind or another. Just two basic asset classes. When it comes to investing your retirement assets, your most fundamental decision is “How do I allocate my assets between those two choices?” Think of it as having your hand on a big dial. Should it be tuned all the way one way or the other, or somewhere in between? Like tuning your stereo. Is it tuned all the way to the bass end or all the way to the treble end? Most likely it’s somewhere in between. (Unless you’re one of those teenagers in the car next to me at a traffic light, with a really loud stereo, and the windows open. And when you bought the car you got ripped off, because the music system only seems to have bass. And you’re using it as some sort of evil secret weapon to cause nearby buildings, and my innards, to shake apart. But I digress.)

So what can you say about these two asset classes?

Stocks. The fundamental nature of investing in stocks is that you own a small piece of a profit-making business. Your share of the business’s profits will either be paid out to you as dividends, or will be retained by the company to meet expenses and fuel further growth. (Because of your tiny equitable ownership of the company’s profits, stocks are often called “equities.”) Your hope is that the company will keep growing in profitability, causing its price on the stock market to go up, and that it will keep paying—or even better, increasing—its regular dividend. But nobody is guaranteeing that this will occur. And nobody is promising to repurchase your stock when you need to turn it into cash to spend; rather, you are relying on the existence of a fluid market—the stock market—to assure yourself that there will be a buyer when you are ready to sell.

Bonds. The fundamental nature of investing in bonds is that you are lending money to the bond’s issuer, and the issuer is promising to repay the amount borrowed, plus interest. You do not benefit from the issuer’s profitability, except indirectly as that bears upon its ability to make good on its promise to repay. A bit of jargon clarification: I am using the word “bonds” to refer to the broad asset class of fixed income investments. Actually, not all fixed income investments are “bonds” in the strict sense of the word, but I will continue to use that nice short single word instead of the more awkward, but technically accurate “fixed income investments.”

To be sure, there are asset classes other than stocks and bonds, but chances are they won’t be part of your retirement investments. Of course there’s real estate. But that’s pretty illiquid, and you probably already have a big percentage of your wealth tied up in your home. There’s commodities. And precious metals. And hedge funds—whatever that means—might be thought of as an asset class. But it’s difficult for an individual to invest in these more arcane asset classes with any degree of confidence. Pretty much, it’s just stocks and bonds.

Professional investors recognize many subcategories of these two asset classes (e.g., U.S. stocks vs. international stocks; long-term bonds vs. short-term bonds). And indeed your assets should be diversified among different sub-asset classes.

There are also hybrid asset classes, with characteristics of both stocks and bonds.

And asset classes with special features attached that make them a little different from either stocks or bonds; like treasury inflation-protected securities, with their annual cost-of-living adjustment; or annuities with their repayment term tied to your heartbeat. These can be thought of as “bond-like,” and put onto the bond side of the dial.

Ultimately, all of your retirement investments can be thought of as one asset class or the other. Your most fundamental and important investment decision is how far up to tune the equity dial.