The Easy Way to Diversify
When my son dumped out the contents of his backpack on the last day of school, here’s a sampling of what hit the floor: An unfinished timeline of the Roman Empire, standardized testing tips (unread), parent notes (undelivered), ripped folders, a moldy Valencia orange, a No. 2 pencil denuded of its yellow paint and lots of wadded-up paper.
Here’s why I’m sharing his motley inventory: If many of the investors reading this column tipped their portfolios upside down and shook out their investments, the contents wouldn’t look any better than the stuff that was jammed inside my son’s scruffy Jansport backpack.
Mishmashed portfolios that are bulging with odd assortments of stocks, bonds, mutual funds, annuities and other flotsam happen because many of us look at the world of investment opportunities from the perspective of a beetle. When you’re less than an inch tall, everything looks big and impressive. Back in 1999, tech fund appeared larger than life. When the market melted tech stocks into a puddle, bond and small-cap stock funds looked like sure bets. Lately people have been slobbering over foreign stock funds.
The problem isn’t with any of these particular asset classes. It’s how you assemble them in your portfolio. Picture what happens when a piñata bursts and frantic kids are stepping on fingers and toes as they grab for Hershey kisses, Skittles, and Nerds. Sure some good stuff gets tossed in the kids’ bags during the commotion, but so does grass and dirt. We get so excited about packing our portfolio with goodies that we wind up with portfolios that are as healthy as a buffet of Krispie Kremes.
What can save us from owning a portfolio stuffed with empty calories? The only way to build and maintain a model portfolio is by diversifying through asset allocation. Here’s a quick lesson on what the heck that is and how to pull it off:
Rule No. 1: When you diversify, you should forget about the tantalizing mutual funds or stocks that you are dying to buy or the mutts you’re itching to sell. In this process, that comes dead last. You should first focus on the asset classes you want to include in your portfolio and then the percentages. By asset classes, I mean major investment categories such as large corporations, small companies, foreign stocks, intermediate bonds and short-term bonds.
At the very start, you’ll have to determine how much of your portfolio should be devoted to the three broadest categories: stocks, bonds and cash. After that, you’ll choose what are essentially subgroups within that trio. For a cash allocation, for instance, someone might use U.S. Treasury bills and a money-market fund. The same investor could spread his or her fixed-income allocation between TIPS and a mutual fund that invests in short-term bonds.
Depending upon how much money you’ve got, your investing smarts and your time horizon, you can invest in more than a dozen asset classes or just a handful.
I can already hear the whining. Focusing on these faceless investment categories makes time spent watching a CSPAN rebroadcast look thrilling. Perhaps this will get you motivated: Back in the 1980s, some famous researchers concluded that asset allocation explains more than 90% of the variation in returns among different investment portfolios. Picking specific investments, they insisted, accounted for only a small amount of the difference between returns. In other words, scouring the likes of Value Line and Morningstar’s data fields to uncover brilliant stock picks is a waste of time. The same researchers concluded that market timing also does little to impact investment results. What counts big time is the asset classes you pick for your portfolio’s foundation.
Rule No.2: Risk is the four-letter word that should be burnt into the frontal lobe of every investor’s brain. The reason why asset allocation is so important is that it helps you to control risk and squeeze out the highest returns possible for the amount of volatility you’re willing to accept. When you spread your bets among different investment categories, you reduce your risk. That way, if your bond fund slips or a foreign fund disintegrates, the blow is softened by your other asset classes that could be levitating above the carnage.
It’s important to understand the potential risks and rewards of different asset classes before pulling any off the shelf. The greater the risk, the higher the potential returns. Let’s look, for example, at Treasury bills. Imagine that one day every American stopped watching TV. Well the chances of that happening are probably greater than the possibility of you losing money on Treasury bills. It ain’t gonna happen. Because the risk is nil, the reward is underwhelming. Since 1925, Treasury bills have generated an annualized return of 3.7%, which barely squeaks past the historic inflation rate. Now let’s contrast that with small company stocks, which, in comparison, can be as scary as a 16-year-old driver let loose on the Merge at rush hour. During the same time period, small-company stocks produced an awesome return of 12.7%. Obviously, the market rewards investors for betting on fledgling companies that may only survive as long as a Chargers’ winning streak.
Lesson No. 3: You might assume that if you accumulate a lot of white-knuckle assets, like small-company stocks, emerging market-debt and junk bonds that your portfolio’s risk level will blow a hole through the roof. Ironically, however, this won’t necessarily happen. That’s because a rainbow-coalition portfolio, which contains assets that look and behave quite different, will actually reduce the risk. For instance, a simple portfolio of blue chip stocks (60%) and run-of-the-mill bonds (40%) actually is considered riskier than a portfolio that keeps the same percentage of bonds, but adds small companies and foreign stocks to the blue-chip equity mix. Strange, but true.
Stay tuned next week for more summertime fun with diversification.
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