This video is a prelude to the concept of diversification, and shows how and why stocks and bonds tend to move in opposite directions.
Why is this? When stocks go up, the market is doing well. Companies are expanding, and borrow more money to grow faster. As a result, interest rates on newly-issued bonds go up. This drives up average interest rates throughout the economy. When interest rates go up, the value of existing bonds goes down. (stocks and bonds slide)
This is a little theoretical, so lets break it down with an example. Lets say the interest rate of a corporate XYZ bond is 6% in 2005. Over the next two years, the stock market starts to go up rapidly. To raise more money for growth, XYZ wants to issue new bonds. But now, because the stock market is generating strong returns, investors want a higher return on bonds to even things out. So, in 2007 XYZ issues new 8% bonds. Because investors can now buy 8% XYZ bonds, the old, 6% bonds are now paying less than the market rate. The market thinks they are less valuable, and therefore they go down in price. Thus, as the stock market improves, the bond market tends to go down, and vice-versa.
Because of this, good financial planning states that it’s a good idea to have a mix of stocks and bonds in a portfolio. This way, even if the equity market is going down, your overall portfolio won’t go down by as much. And when the market improves, you’ll benefit by holding onto some stock. Clearly diversification can benefit your portfolio by reducing your risk.
