Broker Check

Practical Planning Tip: Investing is Like Birthday Cake - The Cake

February 22, 2024

The cornerstone of any birthday cake is the cake itself. There is no debate about this. Without it, you may have an impractical and unappetizing mess of ingredients on top of each other, but it certainly isn’t a cake.

The analogous essential cake part of every investor’s portfolio is a combination of stocks, bonds, and cash. Let’s discuss and define each one of these areas of the market or asset classes.

First are Stocks: Stocks represent an ownership stake in a company. For example, Coca-Cola is a large company that issues stocks. If a member of the public buys one of those stocks, they own a piece of the Coca-Cola company. If Coke goes up in value, the stockholders will make money by owning a share of a more valuable company. They can sell their stock for a higher price than they originally paid to buy it. Conversely, if it goes down, they will lose money. Additionally, Coke offers a dividend, which is a cash distribution, to stockholders. That means stockholders are actually paid part of the profits for owning the company while they wait for it to go up in value.

Technically, stocks have unlimited upside. That’s why they may be the best vehicle for long-term investors who need their money to outpace inflation. However, stocks can also go bankrupt or remain stagnant for a decade or more. This is why stocks are risky and investors need to be prudent when choosing what stocks to own.

Next is Bonds: Bonds are a loan made by an investor to a borrower. The borrower is usually a company or government entity. Bonds are used by companies, municipalities, and states to finance projects and operations. Investors that own bonds typically receive the principal of their loan at a specified maturity date. In addition, over the course of the holding period the investor receives interest payments to compensate them for lending out their money.

Bonds come in many shapes and sizes. Some are very conservative, like Treasury bonds issued by the U.S. government. Other bonds are riskier, with a higher potential for default, like those issued by companies that are not in a strong place financially. Typically, the bond portion of an investor’s portfolio is considered more conservative and serves as a ballast for the more volatile stock portion of their portfolio.

Bond returns typically don’t outpace the rate of inflation over the long-term. Therefore, consistently maintaining too much bond exposure may cause an investor to lose buying power and limit their nest egg’s growth potential.

Finally, lets discuss Cash: Cash is the least exciting investment and usually has the lowest returns since it carries the least amount of risk. However, cash plays a key role in any investor’s portfolio, and is particularly crucial for retirees. As folks are approaching retirement, having a cushion of cash (possibly 2 to 3 years’ worth of expense money) can help mitigate the risk of the market plummeting right before someone needs their money. In such an unfortunate scenario, retirees can withdraw cash without needing to liquidate their investments that have plummeted in value. This cash cushion early in retirement is crucial to helping ensure that investors don’t outlive their money.

Once investors understand the basic stock, bonds, and cash concepts, the key is deciding what percentage of their investments should be in each asset class.

You can WATCH the full video here.