While bonds traditionally earn lower than stocks, that does not mean there isn't a place in your portfolio for bonds. The most common reasons for investors to purchase bonds are below:
1) Diversification: Bonds tends to be less volatile than stocks and can therefore stabilize the value of your portfolio during times when the stock market struggles. Having a combination of both types of investments over the long term can often provide comparable returns with less risk than a portfolio devoted to only one type of investment.
2) Stability: If investors knows they will need access to large sums of money in the near future- for example, to pay for college, a home, etc- then it does not make sense to place that money in a highly volatile investments like stocks. Because the majority of the return on bonds comes from the interest payments (the Coupon payment), fluctuations in the price of a bond will h8ave little impact on the value of the investment.
3) Consistent Income: Unlike stock dividends, coupon payments are consistently distributed at regular intervals. Individuals seeking this consistent income mighty find bonds a better alternate than the dividend payments some stocks offer.
Bonds are often called " Fixed Income " investments, but don't let term fool you. Bonds are not risk less investments. While they are usually considered much safer than stocks, bonds can still lose value while you hold them. Here is a brief look at some of the risk associated with bonds:
I) Interest rate risk: Bond prices are inversely related to interest rates, so if interest rates increase, the price of the bond will decrease. The interest rate on a bond will decrease; the price of the bond will decrease. The interest rate on a bond is set at the time it is issued. Generally, the coupon will reflect interest rates at the time of issuance. However, if interest rates increase, people will be unwilling to purchase the bonds in the secondary market at the earlier rate. For example, if the coupon is set at 6% and the interest rates in the market are at 7%, the interest rate on the bond is well below what you could get from a different investment. Therefore, the price of the bond will decrease so that the capital appreciation will make up for the difference in interest rates. (For this reason, it can be risky to buy long-term bonds during periods of low interest rates)
II) Inflation risk : with few exceptions, the interest rate on your bond is set when it is issued, as is the principal that will be returned at maturity. If there is significant inflation over the time you held the bond, the real value (What you can purchase with the income) of your investment will suffer.
Further reading:
10 reasons why you should invest in stock market--http://retirementsketch.com/archives/11
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