With a solid investment strategy, it is possible to accumulate hundreds of thousands, if not, millions of dollars in wealth over the long term. To do so, you may put together a portfolio of both common stocks and fixed income investments. Common stocks and fixed income investments feature distinct risk versus reward profiles – due to their respective positions within corporate finance. With knowledge of these principles, you can best create a portfolio in line with your objectives.
Fixed income assets, such as preferred shares and bonds, generate level investment income throughout their respective terms. Preferred shares and bonds that are classified as fixed income investments offer level dividend and interest payments, respectively. For example, you may purchase individual preferred shares that make $1 dividend payments in perpetuity. Alternatively, common shares do not feature uniform dividend policy. Corporate management generally adjusts common stock dividend payments according to business profits.
A corporation issues bonds alongside common and preferred shares to secure financing. In terms of seniority rankings, these securities may be listed as bonds, preferred shares, and common shares. This means that bondholders will be paid first from the proceeds of any asset liquidations that arise due to bankruptcy. The corporation is also legally obligated to make bond interest payments, but makes out common stock and preferred dividends at its discretion. Common shares are junior securities, which means they are the last to collect investment income and cash, in the aftermath of any asset sale.
Risks Versus Rewards
Because of their junior asset claims, shares of common stock are riskier investments than fixed income securities. Common stock returns are closely related to corporate profits, which may swing wildly between infinity and zero between economic boom and bust.
In exchange for the relative safety of fixed income assets, you must be willing to accept minimal returns. The smaller returns on fixed income assets expose you to both inflation and interest rate risks. Inflation describes rising prices for goods and services, which erode the purchasing power of your investment principal and future income stream. Alternatively, interest rate risk occurs when prevailing interest rates rise, while you are locked into a relatively low investment income yield. For example, you may own five-year bonds that offer 4-percent rates. These five-year bonds would lose value if rates were to rise and new five-year bonds then pay 7-percent rates.
You can establish a diversified portfolio of money market, fixed income, and common stock investments to manage risks and invest for growth. You should increase exposure to money market and fixed income investments as you age and near retirement. The money market securities provide for liquidity and interest payments that shift alongside the prevailing economy. Fixed income assets, however, would allow you to lock in regularly large amounts of investment income, were rates to actually fall. Lastly, common stock investments are ideal for long-term growth. As a benchmark for U.S. stocks, the S&P 500 averages 11 percent returns each year. For diversification purposes, the SEC recommends that you put money into mutual funds.
Common Stocks Versus Fixed Income Investments, Sources:
Investopedia: Fixed Income Security Definition
SEC: Invest Wisely – Mutual Funds
Investopedia: Common Stock
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