Advanced Diploma of Financial Planning (ADFP) Practice Test

Bonds play a crucial role in diversifying an investment portfolio primarily because they provide a steady stream of cash flows. This characteristic is fundamental to their appeal as a less volatile investment compared to stocks. When included in a portfolio, bonds can help stabilize returns and reduce overall volatility, particularly during periods of economic uncertainty or equity market downturns.

The regular interest payments from bonds (coupon payments) offer a predictable income stream, making them attractive to investors seeking stability and income. This consistent cash flow can serve as a buffer against the price fluctuations that are often seen with equities, especially in turbulent market conditions. Additionally, the performance of bonds can be negatively correlated with that of stocks, meaning that when stock prices decline, bond prices may remain steady or even increase, further enhancing overall portfolio diversification.

This stabilizing effect is important for managing risk within an investment portfolio, enabling investors to balance potential returns with acceptable levels of risk.