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Diversifying Your Investments
by John Jagerson
As earnings season kicks off in October of 2009 the reports look good so far. The stock indexes including the S&P 500 and the Dow Jones Industrial Average are responding by rising still further but does this mean investors should be all in stock? According to the most recent 'Survey of Consumer Finances' that is what almost all investors have done. You should be curious about who is the exception to that trend. The top 10% wealthiest Americans have continued to own stock but have also increased their holdings in bonds and income investments. The other 90% have moved out of bonds so completely it no longer registers on the survey.
What adds more interest to this phenomenon is that over the recent survey period the 10% wealthiest investors have seen an increase of 100% to their portfolios prior to the most recent crash. The gains for the other 90% were barely a third of that. This is not a coincidence. Despite the marketing hype and the excitement around the earnings-game there is a reason to be invested in more than just stock.
Asset allocation and portfolio management are difficult subjects for many investors. This is due in equal parts to the fact that there is a lack of consensus among professionals as to the best way to approach these problems and the issues can be complicated. These complications can be both cognitive (asset allocation requires a learning process) and emotional (greed often conspires against rational investing). However, there is hope to both simplify the issues and to make it achievable for even very small investors to begin understanding and applying the key concepts behind portfolio management.
In this article series we will introduce you to the basic concepts of asset allocation through a three step process. You will learn these basic principles.
1. Determining allocation percentages
2. Should you invest in individual securities (stocks, bonds, futures, etc.) or funds (mutual funds or ETFs)
3. Making adjustments and rebalancing a portfolio
Lets start with determining allocation percentages. Most investment professionals will agree that a blend of asset classes within your portfolio is a good thing but how large those allocations are is a much more cloudy issue. There are basically two factors that you have to consider when deciding on your own allocation strategy.
- How much of a bear market burden can you handle
- What kind of future returns do you want
These two factors are difficult to reconcile. Higher return assets like stocks are often accompanied by very large and unexpected corrections to the downside leading to a large bear market burden. While investment grade and government bonds have a great deal of capital protection they offer low long term returns.
Here is a good example of how two hypothetical allocations acted during different market conditions.
1. An 80/20% mix of stocks to bonds lost -34% in the bear market of 2000-20002 and lost -54% in the bear market of 2008-2009 (so far)
2. A 20/80% mix of stocks to bonds gained 7% in the bear market of 2000-2002 and gained 14% in the bear market of 2008-2009 (so far)
When looked at during these periods the bear market burden seems to bias investors towards a more conservative bond portfolio. However, over longer periods of time that include bull markets, the higher risk portfolio (1) will outperform the lower risk portfolio (2) including inflation by a ratio of 2:1. Finding the right mix for you is the real challenge within asset allocation.
In the video above, we look at how we start solving this problem so that you can refine your allocation yourself. There are concepts that you will learn. First, there are more than two asset classes to choose from and usually the more uncorrelated asset classes you include the better your diversification will be. Second, considering your age and retirement horizon will give you some insight into how heavily you invest in riskier assets like equities. We will start this series by creating a fairly general asset allocation strategy that we can refine as we progress.
Next: Learning to Diversify Across Markets and Within Investment Types
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