In the first three parts of this series, I talked about different options for retirement and non-retirement accounts. I also mentioned that most of the investment in those accounts should be in the form of stock mutual funds. In this post, I am going to talk about one of the fundamental principle of investing: diversification and asset allocation.
Diversification
It is a pretty simple concept and you might already be familiar with it. Let’s get to an example:
Say you have $10,000 to invest right now; would you invest all $10,000 to buy stocks of one company, let’s say Microsoft? Or would you divide that money and invest in few different companies? If you thought investing in few different companies was a better idea, you are already on the right track. By buying multiple companies, you reduce the risk of loosing money. Buying into companies from different industry sector is even better. For example, instead of buying Microsoft, Apple, Google, and IBM (all tech companies) with your $10K, you are better off picking one from Tech, Oil, and Energy sector, and one from Consumer goods, pharmaceutical, and so on. Why is it better to buy companies from different sectors? Because, in any given market condition, there are some industry sectors that do well and some don’t do well. Being invested in multiple sectors minimizes risk of loss in one sector, and at the same time maximizes chance to capture a sector that is doing well.
Even within a specific sector, there are companies of various sizes. They are called small cap, mid cap, and large cap companies (cap = capitalization or market value). A small company can grow much faster than a large company, but are also risky because of their uncertain future. A large company is more stable, but usually do not have huge growth potential. Therefore, you would want to buy both large and small companies so that you can both “grow” your money with a small company, and preserve your money with a large company. You are diversifying your risk to get a best investment return.
Then, there are companies outside United States that should be considered. International stocks, especially the so called emerging markets (countries like India, China, Brazil) have done pretty well in the last decade. So you should have some invested in international stocks to capture their growth. The challengers, in The Economist, talks more about the emerging market.
Bonds and Cash or Cash equivalent.
So far, I have talked about diversification in only one asset class, stocks (or equities as they call it). Besides equities, there are two main asset classes, Bonds and Cash or Cash equivalent. An investor should always have some money in Bonds and some in Cash or Cash equivalent accounts (such as Money Market account or saving accounts). The reason being that bonds and stocks go up or down just as different sector go up or down at different times. Bonds’ prices are determined by different factors than stocks so when stocks market is down, bonds may be going up. Besides, bonds are historically less volatile than stocks. Therefore, bonds and cash act as a buffer when the market is down.
Asset Allocation
Now that we know what different assets are, asset allocation simply means diversifying your investment in different assets. How do you figure out how much of each asset class and categories to hold? That all comes down to the amount of risk you are willing to take. Over a long term (at least 10 years) stocks perform the best, but day to day stocks are the most volatile of all. Therefore, if you invest all your money in stocks for long-term, you have the highest chance of getting the best return among all other asset class. However, if saving for short-term, investing in bonds or keeping it in a saving account is a better idea. You may not get high returns, but your money is safe. Cash is the least volatile, so if you hold cash in saving accounts, you’ll have your cash but the return barely beats inflation.
There are many books and calculators that are available that try to figure out the right asset allocation for you, but it all depends on what level of risk you are comfortable with. Retirement planners or advisers also factor in your age while calculating asset allocation. Since your time frame of investment depends on your age, perhaps you should take less risk as you get old. But, I think as long as you don’t need the money for at least 10 years, the age should not even matter. But that’s just my opinion!
Check out this calculator to play around with asset-allocation. Here is what I got based on the numbers I entered.
This is slightly different than what I am aiming for. My ideal asset-allocation is Large Cap 35%, Mid Cap 15%, Small Cap 20%, Foreign 15%, Bond 15% (I combine bonds and cash).
Using Mutual Funds to diversify
As I have talked about in my previous post, mutual funds provides an excellent diversification because they hold many companies. Index mutual funds are best because of their low cost, and they go as the market goes. So ideally, all you need is 5 funds that each track the five asset class/categories that are mentioned above. If you have a balanced portfolio of index funds, you do not even need to buy any specific sectors. But if you still want to buy, there are all kinds of sector specific mutual funds, such as energy, health care, financials and so on. There are also mutual fund that track International markets, both developed and emerging markets. There are options on bond funds as well. I have to admit, I do not know much about bond market. So I just have a Vanguard Total Bond Market Index fund (VBMFX) to get bond exposure in my portfolio. Since mutual funds have minimum amount required, you can save money in just few funds until you have enough to buy more funds. Once you have all the funds you need, you can invest as little as $50 in a fund. Therefore, it is easy to diversify even with little money.
Remember that you do not need to diversify every investment account. If your 401k is invested in a large cap fund, use IRA to buy a small cap. As long as your regular contributions are distributed according to your asset allocation model, you are fine. Since 401k does not have minimum investment, you can buy multiple fund to achieve your goal. Remember, when you get a company-match at the year end, you contribute a lot at once and that could go heavily in just few funds and throw off your allocation. Plan for that when you make contributions in other accounts. You can even set to distribute your company match differently than your regular contribution.
Useful links.
There are some very good websites that talk about asset allocation and investment in general. I’ve listed a couple below.
2 Comments until now.
As of now and until the governments decide to regulate this out of control market, no allocation of free cash will be safe except in federal securities or stable commodities.
I think Z is right, but with the market as low as it is, there has got to be something that is a steal. Large, established companies who’s price has dropped 10, 20, 30 dollars might be good. Maybe this isn’t a time to buy a lot, but a little here and there might go a long way to building a diversified portfolio.
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