The first thought that comes to investors’ minds when investing is to look for the highest returns. And why not, you want your money to work hard for you.
And therefore, the default choice many investors make, particularly if they are doing SIPs, is to look at investing in equity.
In comparison investing in bonds or debt funds provides much lower returns. So why would an investor consider them to be part of the portfolio?
Sure, the risk involved might be less, but even for aggressive investors with long term horizons, why does debt form such a critical role in your investments?
The answer lies in the different roles played by equity and debt in the portfolio.
Stocks are volatile and whilst they give good returns over the long term, this comes at the cost of sudden movements in the price in the short term – both up and down.
Having bonds adds an element of stability in the portfolio. These instruments by their nature are designed to preserve your money and provide you with an income stream. This is why they don’t move up as much, but also don’t move down as much when compared with equities.
When you mix and match both equity and debt into your portfolio in a defined manner it is called asset allocation. And if you regularly rebalance your money to your target asset allocation, you get the best of both equity and debt.
If the equity markets move up, then at the time of a rebalance you sell your equities and park some money back into debt. Conversely if equity markets have fallen, you would exit from your debt investments and invest it back into equities.
This becomes a natural way for you to book profits when markets have moved up and buy more when the market has gone down. In effect you improve the risk-adjusted-return of your portfolio because you get exposure to the high returns of equities but at the same time have an element of stability in your portfolio provided by fixed income instruments.