Asset Class II: Hot Tips on Developing a Sound Portfolio
I like diverse assets and I cannot lie.
My last post (part 1 of this 2 part series on asset allocation) focused on investment philosophy and four things to consider before developing an investment portfolio.
In case you missed it, here’s a quick refresher: asset allocation refers to the process of dividing investments among different kinds of asset classes to minimize risk and maximize return.
In this post, I’ll take a more indepth look at some of the fundamentals of asset allocation (such as asset classes, and how not to lose your hard-earned green due to a narrow-sighted, or foolish investment approach). I’ll also offer some suggestions on how to set up your personal asset allocation plan, plus strategies that can help should your circumstances change. First up, the big “why?”:
Why is asset allocation so important?
By including within your portfolio asset categories with returns that move up and down under different market conditions, you can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride. If one asset category’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another asset category.
Another way to think about this is to consider why a local business would sell both snow blowers and lawn mowers. Or umbrellas and sunglasses. When someone isn’t needing one, they’re usually needing the other. If that business sold only lawn mowers in Wisconsin, it wouldn’t make much money during half of the year.
Studies have shown that the biggest factor in a portfolio’s variability in returns is due to asset allocation.
Diversity (it’s a good thing!)
Don’t put all your eggs in one basket. There’s a reason this fowl truism is perennially relevant—especially when we’re talking about your money (as opposed to literal eggs, or dating advice from your mother, or someone else’s money).
Diversity is a strategy that involves spreading your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses.
A diversified portfolio should be diversified at two levels: between asset categories and within asset categories. So in addition to allocating your investments among stocks, bonds, and cash equivalents, you’ll also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions.
One way of diversifying your investments within an asset category is to identify and invest in a wide range of companies and industry sectors. Stocks can be described by size (e.g., large cap, mid cap, small cap), growth versus value, and sector (e.g., technology, health, energy, utilities, finance, and many more). But the stock portion of your investment portfolio won’t be diversified, for example, if you invest in only four or five individual stocks.
The easiest way to diversify is to own mutual funds rather than individual investments from each asset category. A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, and other financial instruments. Mutual funds make it easy for investors to own a small portion of many investments. A total stock market index fund, for example, owns stock in thousands of companies. That’s a lot of diversification for one investment!
However, do note: not all mutual funds are created equal. If you haven’t read my prior posts on investment types you may want to do so now. Owning one mutual fund that focuses on only one particular industry sector will not provide you with the diversity you need.
Past performance is no guarantee of future results!!!
There’s a whole big stock market world out there
This may come as a shock to some, but the U.S. stock market isn’t the only market in the world (aren’t I cheeky?). History shows us that the U.S. stock market always rebounds from a crash, usually in a few years time. In fact, there has never been a 20-calendar-year period of negative stock market returns for the S&P 500.
But here’s another piece of financial wisdom that bears repeating and drumming into every investor’s mind: past performance is no guarantee of future results. Past performance is no guarantee of future results!!! Ahem. That’s why there’s always risk associated with investing in stocks and bonds.
The strategy of diversification doesn’t only apply to choosing a variety of asset classes and types of assets within those classes, but also to choosing domestic as well as international investments.
There are a couple schools of thought regarding international investing. Index fund legend Jack Bogle considered international equity investing to be unnecessary, citing how the U.S. has so many advantages in terms of entrepreneurial spirit, sound institutions and solid governance. And given the history of the U.S. stock market, that doesn’t seem unreasonable. But again—past performance is no guarantee of future results!
We can learn a lot from the Japanese market, which hit an all-time high in 1989. Then it crashed. Thirty years later, the Nikkei 225 is still 40% below the 1989 level. After the technology crash in the late 1990’s, people thought it took a long time for the Nasdaq Composite Index to return to normal, but that only took 15 years. If you were reaching retirement age in 1989 and were significantly invested in the Japanese stock market, you would still be waiting for that portion of your portfolio to recover. If, on the other hand, you had invested some of your stocks in the U.S. and other markets, you would not be suffering as much of a loss.
Many people were singing Japan’s praises in the 1980s. Who’s to say that what happened to Japanese stocks could never happen here in the U.S? In the words of Justin Bieber, “Never say never.” Yes, that’s right, I just referenced Justin Bieber.
Risk tolerance is shaped by our experiences. The average Japanese household stockpiles cash to the tune of over 50% of their financial holdings. This compares to just 14% for U.S. households. While there are probably numerous reasons for Japan’s cash obsession—including cultural reasons, deflation and low financial literacy—the terrible stock market performance of the past three decades is no doubt a major factor.
Q. What do radiologists have in common?
A. Each one is different
It’s difficult to recommend specific portfolios because each investor is unique. As I pointed out in my last post, each of us have different goals, time frames, risk tolerances, and personal financial situations. You may also be invested in retirement plans that limit your investment options. The White Coat Investor provides an example of “150 portfolios better than yours.” If you’re looking for an easy way to achieve diversity, you can go with one of the options below.
Lifecycle funds (one-stop shopping)
Perhaps the easiest option for investing is to own a “lifecycle” or “target-date” fund. A lifecycle fund is a diversified mutual fund that automatically shifts towards a more conservative mix of investments as it approaches a particular year in the future, known as its “target date.” A lifecycle fund investor picks a fund with the right target date based on his or her particular investment goal. The managers of the fund then make all decisions about asset allocation, diversification, and rebalancing. It’s easy to identify a lifecycle fund because its name will likely refer to its target date. For example, you might see lifecycle funds with names like “Portfolio 2015,” “Retirement Fund 2030,” or “Target 2045.”
To achieve diversity and have a little more control over the allocation of stocks and bonds (which you might want when selling investments), you can invest in a combination of 1) total stock market fund, 2) total international stock market fund, and 3) total bond market fund. All of the major mutual fund and brokerage companies (e.g., Vanguard, Fidelity, Schwab, TD Ameritrade, and others) offer such funds that have very low expense ratios.
How much should you invest in stocks versus bonds?
Again, there is no hard and fast rule here because everyone’s situation is unique. In general I suggest investing some amount in bonds because it will smooth out ups and downs of the market and might prevent you from selling when the markets crash. If you still have 20 or more years to invest before retirement, you might invest 80% in stocks and 20% in bonds. As you get within 10 years of retirement, you might dial back the percentage of stocks. By then, you will have fewer years for stocks to grow and the added gain may not be worth the added risk. Some people switch to 50% stocks and 50% bonds around the age of 50. Depending on the size of your portfolio, you may decide to maintain that allocation indefinitely. Or at some point, you may want to move to a portfolio of 20% stocks and 80% bonds. Some people recommend a bond allocation equal to your age (i.e., at age 50 you would invest 50% in bonds).
What if plans change?
The most common reason for changing your asset allocation is a change in your time horizon. As you get closer to your investment goal, you’ll likely need to change your asset allocation. For example, most people investing for retirement hold less stock and more bonds and cash equivalents as they get closer to retirement age. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself. For example, you may start working part-time and cut your income in half. You may increase your family size (triplets—yay!). And the Medscape Radiologist Lifestyle Report 2018 showed a 5% divorce rate among responding radiologists.
Rebalancing for the win-win
Over time, you’ll find that your asset allocation no longer represents your intended mix. This is because some of your investments will grow faster than others. For example, after a stock market increase, your stock allocation that was once 50% of your portfolio may now be 60% of your portfolio, and your bond allocation that was once 50% of your portfolio is now 40% of your portfolio. What do you do? You rebalance to bring your portfolio back to your original asset allocation mix.
You can do this in two ways. If you are still contributing to your account, you can invest less in stocks and more in bonds. If you are no longer contributing or not contributing enough to completely rebalance, you can sell off investments from over-weighted asset categories (i.e., stocks in this example) and use the proceeds to purchase investments for under-weighted categories (i.e., bonds in this example). You will want to be careful about selling funds in a taxable account, as it could trigger a taxable event (which is not an issue when rebalancing in a non-taxable account).
With rebalancing, you are shifting money away from an asset category when it is doing well in favor of an asset category that is doing poorly. You may be uncomfortable cutting back on current “winners” and buying more “losers”, but by doing so you are “buying low and selling high.” Win-win.
When should you rebalance?
You can rebalance your portfolio based either on the calendar or on your investments. Many financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider rebalancing. Others recommend rebalancing only when the relative weight of an asset class increases or decreases more than a certain percentage that you’ve identified in advance (say, 5%). The advantage of this method is that your investments tell you when to rebalance.
Those are the basics of asset allocation. If you’re investing on your own, I’ve offered some simple options. But don’t be afraid to get professional financial advice (as long as it’s good advice at a fair price, which I’ve discussed in a prior post). There are many ways to skin a cat, more than one way to crack an egg, and more than one road leading to Rome. All trite idioms aside, the point is that there are many potential solutions for meeting your unique investment goals.
I’ll leave you with one last bit of advice. Pick a plan, after thoughtfully determining your goals, timeframe, risk tolerance, and personal financial situation, and STICK WITH IT. Change your plan when one of the four considerations changes but NOT according to market fluctuations.