Asset allocation in a balanced fund allows investors to create an investment strategy that is relatively low-risk and high-reward. Conservative funds consist of fewer equities and more bonds, while aggressive funds comprise more equities and fewer bonds.

 

Diversification

Balanced funds provide investors with diversification. By diversifying the investment across different asset classes, the investor mitigates the risk that they will otherwise face if they’ve invested in a 100% equity fund or 100% bond fund.

In a scenario where volatility occurs in one industry, a balanced fund portfolio will experience less fluctuation compared to a pure equity portfolio investing in the same industry. While a balanced fund does offer diversification, the securities selected and the weightings of each asset class may not be aligned with the holder’s investment goals.

 

Risks Associated with a Balanced Fund

A balanced fund is attractive to investors with low-risk tolerance because the fund’s growth outpaces inflation and provides steady returns. While balanced funds are a comparatively conservative investment strategy, they are still not 100% risk-free because bonds will fluctuate if interest rates change. Since bonds demonstrate an inverse relationship with interest rates, an increase in interest rates will cause bond values to fall.

 

Bonds vs. Interest Rate Example

Let’s assume an investor buys a two-year bond with a face value of $1,000 and an interest rate of 5%. If the interest rates remain the same, the bond will yield $50 each year over the two-year period.

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If the interest rate was to rise to 6%, the investor will now able to buy new bonds with a higher yield, equating to a $60 return each year. With new higher-yielding bonds coming to the market nowadays, the previous ones become unattractive because of their lower yield. In order to become competitive again, the older bonds would then need to sell at a discount.

 

Stocks vs. Interest Rate Example

With any investment, the investor is paying the price today for expected money in the future, which is the time value of money concept. It is noticeable with bonds when interest rates go up and bond values decrease since the investor is willing to pay less for future cash flows.

The difference with stocks when comparing them to bonds is that the future value of the stock is variable. In our example, if the future value of the stock is fixed, just like with a bond, and the interest rate rises, the investor expects to receive less money from the stock in the future. For stocks, future cash flows are not guaranteed, but with bonds, they are.

 

Conclusion

Balanced funds are ideal for an investor who wants a combination of a low risk (investments in bonds) and a higher risk (equity investment) return profile. Diversification will lower the risk of holding only stocks or bonds, and if interest rates are not expected to increase, the bond component will not experience notable fluctuations.

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