Debt instruments fluctuate less in value over time. But they do not offer the long term growth potential of equities. A defensive investment plan using bonds and money market instruments must sacrifice the potential for higher returns.
Investors with longer term horizons may still demand bonds if there is the need for a fixed income cashflow from investments, or if the investor is psychologically risk-averse and feels uncomfortable with short-term falls in value. Debt instruments offer more stable, but lower overall returns. Income can be generated from equities - from dividend payments or from selling shares but dividends are not guaranteed, and income from selling shares may result in fall of portfolio value. So bonds provide a certain income-stream for the more conservative investor.
1. Long term investors must learn to live with intermediate swings in equity value without getting too carried away by either optimism or pessimism.
2. Long term investors who cannot cope with temporary, short-term falls in value need to hold a proportion of their assets as bonds.
3. Shorter term investors must always hold a high proportion of assets as debt instruments (bonds and money market instruments) to prevent against the risk of having to recoup cash value at a time when stock markets are performing badly.
Let's see what this means in terms of an asset allocation mix.