Personal Finance Education Series: (5) Diversification & Asset Allocation

It has been quite a while since I’ve posted as part of my personal finance education series, but it hasn’t been for lack of desire to do so. This is the first post that starts getting into topics on investing, and as a result, it has taken me a bit of time to collect my thoughts.

If you haven’t had a chance to review the previous two posts on Saving and Emergency Funds, please do so. It only makes sense to start talking about investing for the long term when you have the basics of good financial hygiene in place. It makes no sense to own stock in Google or money in an exchange-traded fund if you are having trouble paying off your credit card.

Of all the chapters to come in this series, however, this one is probably the most important to take to heart as you manage your own long term investments.

It turns out that the most important decision for your investments is not trying to find the next hot stock nor trying to find the savings account that pays the highest rate. It’s not finding the best new type of bond to own, and it’s not finding the lowest expense ratio. These are all important, but most likely not the biggest determinate of your investing success.

It turns out the most important decision you make with your investment dollars is how you divide your assets between different types of investments. This one decision tends to explain the majority of success and failure that people see in their investment portfolios.

Let me explain, at a high level.

It turns out that there are many different ways to invest your money. These different types of investments have different characteristics. Some people over-simplify this to whether one type of asset is “riskier” than another, but it turns out that risk comes in many flavors.

Some investments have returns that are very unpredictable in the short term. Others are extremely predictable. This is sometimes referred to as volatility.

Some investments require your money to be locked up for long periods of time. Others provide you easy access to your money. This is sometimes referred to as liquidity.

You have probably heard the names of a lot of different types of investments thrown around:

  • Cash
  • Bank Accounts
  • CDs
  • Money Market Funds
  • Bonds
  • Stocks
  • Mutual Funds
  • ETFs
  • Gold
  • Timber
  • Real Estate
  • Commodities
  • etc…

There are no shortage of different types of investments out there. Each has its own characteristics; its own strengths and weaknesses. What makes it even more confusing is that some types of investments, like mutual funds and ETFs, are really just structures that invest in other types of investments (like stocks & bonds).

The whole idea behind diversification is a reflection of that age-old advice “don’t put all of your eggs in one basket“. By spreading your money around to different types of investments intelligently, you increase the chance that when one of your investments goes down, another will be up. This smooths out the ups and downs, and makes it much more likely that you’ll hit your investment goals.

For most people who don’t have truly large sums to manage, there are only three types of assets that are applicable to most savings goals like retirement or college. They are:

  • Cash
  • Bonds
  • Stocks

Cash investments can take many forms. Some people keep their case in bank accounts or money market funds. Historically, cash investments tend to barely return any money after inflation, which means that they pay interest rates that increase roughly at the same rate that prices increase. They are the definition of liquidity, typically offering you access to your money easily and on extremely short notice.

One of the common mistakes that people make when investing for long term goals is keeping too much money in cash. Because of the low returns, over long periods of time, cash can act like a big anchor on your portfolio, limiting your ability to compound your returns over time.

Assuming you have an emergency fund of three to six months in cash, the purpose of cash in your long term portfolio is really just for three things. First, it cushions downturns in the market, since your cash portion never goes down. Second, it provides you with extra money to invest when other assets become relatively cheap. Third, it provides you with liquidity. It’s terrible for your returns to be forced to sell other assets when they are down, just because you need the money. Cash is always there for you, protecting you from yourself, making sure you don’t end up buying high and selling low.

Bonds come in many different flavors, but fundamentally all a bond is a loan. If you need to borrow a large amount a money, one way to do it is to sell bonds. For example, a company can easily “borrow” $1 Billion by selling 1 million $1000 bonds. The buyers of the bonds get a piece of paper that promises them their money back, sometime in the future, plus interest.

Bonds have been around a very long time, and as a result, there is every imaginable variety. You can find bonds from governments and companies, bonds based on mortgages or utility revenue. There are bonds that pay interest every 6 months, or only at the end of the term.

Historically, bonds have returned an average of about 1.7% above inflation, so while you will see your money grow, it won’t grow quickly. This number, of course, is a horrendous average – there are many varieties of bonds with their own histories and returns. Fundamentally, however, most people turn to bonds when they want to see higher returns than cash, and they are willing to sacrifice liquidity to get it. By locking up your money for a longer period of time, you hopefully will see higher returns.

Bonds have a lot of unique risks. There is the risk that the company will default on the bond, and never pay it back, known as default risk. There is the risk that interest rates will go up, making the bond you bought at a low rate less valuable, known as rate risk. There is the risk that inflation will grow, effectively erasing the value of your bond interest, known as inflation risk. If you want to get fancy, there is even currency risk, since your bond will tend to be denominated in only one currency.

Right now, the interest rates available on cash investments are so high relatively to bonds, that some people advocate not putting any money in bonds right now. Most financial planners, however, will tell you that keeping a set mix of stocks & bonds will smooth out your long term returns significantly, and lower the risk that you’ll end up missing your investment goals. Historically, there have been long periods of time where bonds outperformed stocks, and having money in bonds can ensure that when stocks are underperforming, your portfolio will survive to fight another day. Ben Stein captures this really well in his recent book, which I reviewed here.

Personally, I tend to group cash & bonds together in my asset allocation, since I find it useful to think of cash as just another type of bond that happens to have very high liquidity, and relatively lower returns. Sometimes, however, cash can be the best place for the “fixed income” portion of your portfolio at times. Right now, it’s hard not to like the 5.05% you can get at E*Trade or EmigrantDirect on a bank account with no minimums and liquidity.

Stocks are the most common basic investment in modern personal finance for achieving long term investment goals. Historically, they have returned approximately 6% over inflation, meaning that they are one of the few asset classes to aggressively grow your spending power over time. Stocks are really just pieces of paper that give you part ownership in a business. When a company like eBay has 1.7 Billion shares, each share is like owning a little piece of the overall business.

Stocks are incredibly liquid, and are now freely traded world-wide. Stocks are also incredibly volatile, with prices moving up and down every minute, every day. Because of this, stocks have a reputation for being risky. If you have all of your first house down payment in stocks, it is possible for that account to drop more than 20% in a single day, and that’s bad news if that’s the day before closing.

In the long term, a diversified portfolio of US stocks has been an incredibly rewarding investment. As a result, people have a hard time balancing the short term risk of stocks with the long term risk of not owning stocks.

For most people, even those in retirement, a significant portion of your portfolio likely belongs in stocks. However, it is extremely important to balance that investment with other assets, and to be realistic about how much volatility your investment goals will allow for.  Most Americans have too much of their long term savings in cash, and too little in stocks.

There are over 9000 public stocks in the US alone, and there are many different kinds of stocks.  There are giant companies like General Electric & Microsoft, and tiny companies you have never heard of. As a result, having a diversified portfolio of stocks is likely the most important aspect of this asset class.  I’ll post a whole separate chapter on this topic.

This has been an extremely long chapter, and we haven’t even scratched the surface on some of these topics.  There is one last topic I want to illustrate, and that is the benefit of rebalancing your portfolio based on an asset allocation strategy.

Let’s take a hypothetical portfolio of $10,000 broken down as:

  • 10% Cash:  $1000
  • 30% Bonds:  $3000
  • 60% Stocks:  $6000

Let’s assume that the Bonds and Stocks are represented by broad, cheap index funds from Vanguard.

Let’s say that Year 1 is really bad for stocks, and mediocre for bonds and cash.  Stocks return minus 10%, and bonds return 4%, and cash returns 5%.  Your portfolio becomes:

  • $1050 Cash
  • $3120 Bonds
  • $5400 Stocks

No question, it’s bad news.   Your portfolio is now worth only $9570.  However, if you had been 100% in Stocks, you’d be down to $9000.   The Bonds & Cash cushion the blow of a bad year on the market.

Since your goal is a 10%, 30%, 60% split, you want to rebalance your portfolio once a year.  This means moving your money around so that you now have:

  • $957 in Cash (10%)
  • $2871 in Bonds (30%)
  • $5742 in Stocks (60%)

Basically, you move money from the assets that did well this year, into the assets that did poorly.  This may seem counter-intuitive to those who believe in going with their winners and selling their losers, but this single act encapsulates one of the most practical benefits of a good asset allocation strategy:  it forces you to sell assets that are high, and buy assets when they are low.  Assets tend to regress to their average performance, so this rebalancing has been proven to be a winning strategy to avoid the very human mistake of buying investments when they are high, and selling them when they are low.

Let’s look at what happens in Year 2, assuming that an “average” year happens.  Cash returns 3%, Bonds return 5.5%, and Stocks return 10%.

  • $986 Cash
  • $3029 Bonds
  • $6316 Stocks

As you can see, by moving money into Stocks after the down year, the portfolio is set up for better performance when stocks do, inevitably, recover.  This wouldn’t be possible, however, without having money in different asset classes.  It also assumes extremely good diligence and fortitude to rebalance every year.

Whew!  Long chapter.  A lot of great topics.  For those of you waiting for more detail on each asset class, I plan on having the next few chapters focus on individual asset classes and investment goals.

5 thoughts on “Personal Finance Education Series: (5) Diversification & Asset Allocation

  1. Some ideas for future (more advanced topics) —

    What about using leverage in a typical portfolio? Or perhaps using it creatively?

    For example, I’m trying out an investment strategy now where for my Large Cap allocation, I put 50% in an ETF designed to do 2x the performance of the S&P 500. I then put 50% in the maximum yield money market at Schwab (5%).

    The result? Theoretically, my large cap allocation now has a Beta of ~1.0 since its 50% risk-free (Beta = 0) and 50% at 2x the market (Beta = 2). [Practically, of course, this theoretical result is never reached because the ETF doesn’t always perform as desired — it also tries to match daily moves in the S&P 500 rather then aggregate performance. I’m trying this out now to see what difference this makes, I suspect I can also dynamically reallocate to adjust to underperformance. ]

    In either case, assuming you buy the Beta = 1.0 argument, my returns are always guaranteed to be above the S&P 500 — since, the ETF returns 2x for 50% of the money for a return equivalent to a 100% investment in the S&P500. Menawhile, the money market returns an additional 5% for 50% of the money, so 2.5% over the whole portfolio.

    Subtracting fees/commissions (1%), that’s 1.5% over the S&P 500 every year — a pretty good large cap strategy …. 🙂

  2. Hi Elliot,

    Your strategy isn’t actually dissimilar from what a lot of index funds do. The way that funds can “double” the return of an index is by using derivatives, like futures contracts, to exaggerate moves in the index. Usually, even normal index funds do this a little because they have to maintain a certain amount of cash on hand to deal with new contributions or withdrawals. This would be a drag on their returns, so the use futures to close the gap.

    My guess is, however, that the actually risk profile of the fund with double the market return is actually slightly higher than 2.0. Derivatives have a “risk-free return” built into them, similar to your cash return, so there is no free lunch. Your portfolio mix will likely return a bit more than the market on the upside and lose a bit more than the market on the downside, because my guess is that the risk averages to more than 1.0.

    In addition, the expense ratio on your double-return fund is likely quite a bit higher than a normal index fun, which can be as low as 7 basis points these days.

    Still, your strategy has a lot of merit in terms of providing more liquidity in your portfolio. By maintaining half the portfolio in cash, if you are regularly rebalancing, it will have the effect of buying more when the market is down.

    I think if you use your mix in my example above, it will turn out even better because the Year 2 gain for stocks will be doubled for the 50% you have in that fund.

    It’s worth thinking about – I wrote this article really as a basic 101 on asset allocation, so concepts like “enhanced” index funds and derivatives aren’t included.

    I’m impressed you read through the whole thing! 🙂

    Adam

  3. Hi,
    I came across your blog through DebtCC Blog Hunt and it impressed me a lot.Your education on personal finance helps me a lot.Bunch of thanks to you and DebtCC Blog HUnt.

  4. It has been stated in many books, mag, etc to expect on average 9% growth per year for stock over the long term. I understand this has been the historical number. But, I don’t understand why stocks should out perform inflation. There are bad stocks and good stock, I have worked for 3 startups: 1 IPOed then went under, 1 IPOed then got acquired, and one went under. I had SGI stock forever and it got delisted (or will be I can’t keep track any more). My question is there are good companies and bad companies, seems to me that the average for all the companies can’t grow faster then economy (or the world wide economy). So why should stock outperform the inflation?

    Can it be the study is only based on surviving companies or some other pre-conditions? What if they included every companies that ever IPOed. Would that number still be 9%?

  5. Hi Ricky,

    The exact number depends on the historical time period. The reason that stocks have historically returned approximately 6% over inflation (around 10% including dividends) is as follows (in the roughest of rounded numbers):

    4% Inflation
    3% Productivity Growth
    3% Dividend Yield

    The reason stocks should always grow more than inflation is because companies deliver efficiencies and productivity growth every year, on average. That gives you a few percent above inflation. So capital appreciation tends to reflect that earning power, and you get a yield a few percent above inflation. In addition, stocks pay out portions of their cash flows as dividends, so that adds to your yield as well.

    A lot of people believe that because inflation is low now historically, and stocks pay out lower dividends on average, that the long term return on stocks going forward will be lower.

    The number of studies on the long term returns of stocks are too numerous to count. You can debate the future performance of stocks, but not the past at this point. The returns differ depending on what time period you look at.

    The whole point of my article above is that you should not be looking at individual stocks as a representative of the asset class. You don’t want to have your retirement portfolio in SGI. You want to have a diversified portfolio of common stocks. If you own the Vanguard Total Market index, you will have a small piece of every publicly traded company.

    Adam

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s