Every financial adviser you will ever talk to and every investment article that addresses portfolio diversification will tell you to put some of your money into stocks and some of your money into bonds. But why?
The reason: stocks and bonds typically don’t move in the same direction—when stocks go up, bonds usually go down, and when stocks go down, bonds usually go up—and investing in both typically provides protection for your portfolio.
[VIDEO] Understanding How Stocks and Bonds Work Together
Why Stocks and Bonds Typically Move in Opposite Directions
Stocks and bonds typically move in opposite directions because they are fighting for the same money from investors.
When investors use their money to buy stocks, they have that much less with which to buy bonds. Conversely, when investors use their money to buy bonds, they have that much less with which to buy stocks.
Oftentimes, investors will also sell bonds to raise money to buy stocks or sell stocks to raise money to buy bonds. When this happens, the price of both asset classes are affected.
Here’s how it works:
– When investors buy stocks instead of bonds, stock prices go up and bond prices go down
– When investors buy bonds instead of stocks, bond prices go up and stock prices go down
Why Investing in Both Stocks and Bonds Provides Protection
Diversifying your account by investing in both stocks and bonds provides protection because you can offset some, or all, of your losses in one investment with the gains in the other investment.
If your stock holdings lose value because stock prices are going down, your bond holdings may offset those losses if bond prices are going up.
The opposite is also true, if your bond holdings lose value because bond prices are going down, your stock holdings may offset those losses if stock prices are going up.