The best way to manage investment risks is to diversify your investments. You’ve heard the saying that you shouldn’t put all your eggs in one basket. This bit of folk wisdom is the best way to manage investment risks.
Diversification means that you hold a variety of different types of assets. Stocks, bonds, bank or credit union CDs, real estate, cash are assets typically held by ordinary investors. Commodities and collectibles are riskier, and best left to those with significant wealth. There is no magic formula for diversification. No one knows what the future holds, so all diversification recommendations are educated guesses at best. But experience and history allow us to make some reasonable educated guesses.
Use Packaged Diversification. For ordinary investors, packaged diversification in the form of mutual funds is one of the easiest ways to protect against investment risks. One type of mutual fund called the "lifecycle fund" may provide one of the most convenient diversification packages. A relatively new product called the “exchange traded fund” or ETF is also available. It has its uses, but is not ideal for someone just starting out. Comparing mutual funds against ETFs, the ordinary investor is likely to be better off starting out with mutual funds.
The best way for an ordinary investor to deal with the multitude of investment risks is to diversify his or her investments. No asset goes straight up in value all the time. Instead, investment values fluctuate. If you invest primarily in one type of asset, you could be caught by a downdraft in the market for that type of asset and lose a bundle. Put your eggs in many different baskets, and it becomes much harder to lose a large part of your portfolio. The potential for large, short term gains is also lower with a diversified portfolio. But you’re more likely to hold onto your hard-earned money in the long run, which is what really counts.
Diversification helps to protect against virtually all investment risks. Performance risk, interest rate risk, cyclical risk, and fraud risk are all offset to some degree by diversification. Comprehension risk remains, but that can be handled only if you learn the ins and outs of the investment in question. Even for well diversified investments like many mutual funds, you still have to learn how they work.
What Does Diversification Mean?
Diversification in its simplest form means investing in a variety of different types of assets. This reduces the potential for a truly catastrophic loss. Some of your assets could, in any given year, fall in value. But other assets could rise, and help to offset the losses. There are times when almost all asset classes fall in value, but there are also times when almost all asset classes rise in value. By investing in a diversified way, you reduce your overall long term risks. While you also reduce your potential for gains, that is the logical consequence of controlling risk (remember that risk and reward walk hand-in-hand down Wall Street). Your best bet for building wealth for retirement is to save steadily and invest prudently. Making the big score happens in movies, but rarely in real life.
Many people diversify without consciously trying. Owning a home and having money in an interest bearing checking account provides a degree of diversification—you have an investment in real estate and another in a short term interest bearing asset. Owning a few mutual funds or stocks on top of that, and the person is even more diversified. While there is an enormous variety of different stocks, bonds, mutual funds and other investments, you need not own more than a small fraction of them to be reasonably diversified. And you need not do a lot of investment research or hire expensive advisers.
The financial services industry devotes a great deal of effort to making competing proclamations about the ideal diversified portfolio. For example, one prognosticator might recommend that you put 74.3% of your assets into stocks, 20.6% into bonds, and 5.1% into bank accounts like CDs. Another, trying to be more sophisticated, might suggest 61.44% in U.S. stocks, 18.46% in foreign stocks, 20.1% in bonds, and 0% in cash. A third, in an effort to display even greater erudition, might recommend 43.22% in U.S. large cap stocks (stocks of large companies), 20.78% in U.S. small cap stocks (stocks of small companies), 10.4% in Asian stocks, 11% in European stocks, 11.5% in bonds and 3.1% in cash. As you can see, the ways to slice and dice investment diversification are endless, and they can become increasingly complex and hard to understand.
On the other hand, we could recall that virtually no professionals on Wall Street predicted the major downturn in stock prices in 2000-2002 (or, for that matter, the famous stock market crash in 1929). No one can predict the future with certainty, including MBAs in finance. All diversification formulas—which necessarily are based on a prediction of how financial assets will perform in the future —are educated guesses at best. That being the case, how can one decide which diversification formula to use?
While no particular mix of assets will necessarily be right, experience and common sense tell us that some asset mixes are better than others. We will suggest diversification mixes in our model financial plans. First, let’s cover a few basics.
Types of Assets
Common financial assets include:
Cash, which is important for protecting you from short-term personal risks, like layoffs, illness, injury and other circumstances where your earning ability is impaired. Cash won’t generate much profit, but that’s not its purpose. It is a buffer that protects you from having to liquidate your retirement investments or go into debt at an inopportune time, either of which could negatively affect your retirement plans. Avoiding loss is as important as increasing assets. Keep a stash of cash handy as an emergency fund, enough for three to six months of living expenses. To get some interest on this cash, invest it in a money market fund, or a bank or credit union money market account. All of these accounts allow you immediate access to the funds, which is important for emergencies. The interest rates paid on money market funds and bank or credit union money market accounts will fluctuate—money market funds will generally give you a competitive rate, while bank money market accounts tend to be less generous (except at some online banks). Credit union accounts may pay better rates than bank accounts. A money market fund that invests only in U.S. Treasury securities is a very good choice for an emergency cash fund. It will be quite safe (as its investments are the obligations of the federal government), the interest rates are likely to be competitive and the funds will be immediately accessible. However, not being a bank account, it can’t be accessed as conveniently as a bank account (such as through an ATM). But that’s an advantage since you don’t want to tap into your emergency fund except in case of a real emergency.
Stocks have generally been good long term investments. In the broadest sense, holding stocks is like betting on future economic growth. People worldwide want better futures for themselves and for their children, and will work for it. The fruits of their labor are reflected in economic growth, which in turn will improve stock values. This is where the long term investment value of stocks comes from. The world economy, and in particular the U.S. economy, have grown pretty well since World War II. As a result, stocks have been a good investment over the long term.
One point about stocks: the advantageous returns that stocks have historically offered assume that you reinvest the dividends paid by the companies issuing the stocks. If you don’t reinvest dividends, the returns you get will be noticeably lower than historical rates. Don’t spend the dividends you receive in your working years. Reinvest them—either in the stocks that paid the dividends or in other investments--and reap the rewards later in life. Reinvesting dividends is a crucial part of the process of compounding. As we have said before, if you love compounding, compounding will love you.
Real estate has generally been a good investment since WW II. Housing, as noted in our discussion of real estate, hasn’t been as profitable overall as stocks. But you need shelter and buying it will usually make sense since you will not only buy the shelter but capture the appreciation in the home’s value.
Bonds are a way for you to invest in the debt of governments and corporations. They consist of a promise to repay the amount of money borrowed, plus interest. Companies, cities, school districts, other public organizations, and the great granddaddy of all borrowers, the U.S. government, all issue bonds. Bonds generally provide lower profits than stocks, but tend to be more stable in value. They are usually used to provide a conservative element to your investment portfolio. However, sharp increases in interest rates can noticeably damage the value of bonds. There have been times when bonds have done quite well. The early 2000’s, when interest rates were falling, were salad days for bond investors. But more recent rises in interest rates have lowered the profitability of bond holdings. Bonds are a useful way to provide a degree of stability to the value of an investment portfolio.
Inflation Protected Bonds. Inflation is the arch enemy of retirees and bond investors. Inflation reduces the value of the dollar, a fact that allows borrowers to repay lenders with cheapened currency. Thus, bonds tend to lose value during inflationary periods. You, as a bond investor, are the lender and you will take the loss from inflation. In theory, the interest payments on bonds should be high enough to compensate for the risk of inflation. But fact and theory sometimes take different forks in the road; if inflation is higher than expected, you're up the creek. There are bonds that provide inflation protection (U.S. Treasury TIPS and inflation adjusted U.S. Savings Bonds are examples). However, they may have some complicating features.
TIPS are adjusted in value each year by the increase (or, rarely, decrease) in the Consumer Price Index. The amount of that increase is not paid out to the investor until the TIPS mature, which can be years later. However, the investor is taxed on the annual increase in the TIPS each year and has to have other current sources of cash to cover that tax obligation. In addition to the inflation adjustment, TIPS also have a fixed interest rate (established at the time the TIPS is issued by the Treasury Department) and make cash interest payments every six months. This fixed interest rate is meant to cover the cost of borrowing, rather than the effects of inflation. These interest payments will vary in amount because they are based on the adjusted principal value of the TIPS (after it has been increased or decreased for inflation or deflation). These cash interest payments can be used to cover tax liabilities. But the interest payments themselves are also taxed, and may not provide enough cash to cover the combined tax liabilities from the TIPS. So you might have to find cash from other sources to cover the taxes on the TIPS. Also, TIPS are subject to market losses and gains—in other words, if you want to sell a TIPS before it matures, you might get more or less than its inflation adjusted amount because of fluctuations in market interest rates.
There are some mutual funds that focus on investing in inflation-protected bonds. They may hold a mix of government and other inflation-adjustable bonds.
I Savings Bonds (the inflation-adjusted Savings Bonds) also increase in value by the change in the Consumers Price Index and pay interest as well. (One probably minor detail is that, unlike TIPS, I Savings Bonds won’t decrease in principal value even if deflation occurs—but given that the last time the U.S. saw sustained deflation was during the Great Depression, this isn’t a significant reason to prefer I Savings Bonds over TIPS.) An advantage of the I Savings Bond is that its inflation adjustments are not taxed until the savings bond matures, or until the owner redeems it. That way, you have less of a cash flow crunch than you’d have with TIPS. If, however, the owner redeems the bond less than five years after purchasing it, he or she will be charged the interest for the last three months as an early withdrawal penalty.
Inflation protected bonds like TIPS and I Savings Bonds can be used by the ordinary investor to preserve money that he or she can’t afford to lose. The I Savings Bond may be the more useful of the two. It can be purchased in very small quantities (the minimum amount is $25, while the TIPs require a minimum investment of $1,000). Also, its inflation adjustments are not taxed until the bond matures, so you have less of an ongoing cash flow problem than you’d have with TIPS. But note that because the inflation adjustments on both the TIPS and the I Savings Bond are taxed, you don’t really get complete protection from inflation--some of the protection goes to the IRS. The interest and inflation adjustments from I Savings Bonds can be exempt from taxation if they are used for specified educational purposes and the owners of the bonds have incomes under certain limits (see our discussion of saving for college expenses for details). If you are eligible for the tax break and use I Savings Bonds for educational purposes, you will get the full value of the inflation adjustment. But neither the I Savings Bond or the TIPS are likely to provide long term returns as high as the stock market’s returns. So when you're investing for long term goals, some of your money probably should be invested in stocks.
Certificates of Deposit are bank or credit union accounts which generally have a fixed term and a fixed interest rate. CDs are first cousins of bonds, and can be used for similarly conservative investment purposes--to obtain a fixed return over a specified period of time with your principal likely to be repaid. Indeed, bank and credit union CDs will almost always be federally insured up to $100,000 ($250,000 for retirement accounts), so the likelihood you'll be repaid for CDs up to these limits is essentially 100%. In keeping with their low risk of loss, CDs tend to provide low returns. However, you don't invest in a CD for large profits; you invest in it for safety and security.
Commodities and Collectibles. Some commodities, like gold or silver, can serve as investments. Here, we're talking about actually owning gold, not trading in commodities futures contracts, which are much too risky for ordinary investors. (The risks of commodities futures contracts are briefly discussed in at the beginning of our section on investment risk.)
Assets known as collectibles, such as stamps, coins, art, books and antique cars, can also increase in value over time and therefore serve as investments. As for jewelry, we've all heard that diamonds are a girl’s best friend. All of these items may have investment value. However, commodities, collectibles, and jewelry are pure speculations. They do not generate income, like interest from a bond or bank account or dividends on stock. Their value can meander for years, and appreciation is by no means predictable, let alone certain. Sometimes, they'll decrease in value. If they don’t go up in value, you get no profit or income. Also, they can be illiquid. For example, getting top dollar for a comic book collection might take months, or even years. If you enjoy owning these things, that might be reason enough to buy them. But be cautious about relying on them to get you on the S.S. Shuffleboard when you’re 65.
People with substantial financial wherewithal have a reasonable chance to profit from commodities and collectibles. Ordinary investors should be cautious.
Ways to Diversify
The historical way for an ordinary investor to diversify was own some stocks, some bonds, a house and some cash. Investing this way was quite common back in the days when color television was a novelty. But it required the individual investor to do quite a bit of research and perhaps take more risk than he or she intended. Although many stock market aficionados still invest this way, things have improved considerably for the small investor since then.
The easiest way for the ordinary investor to diversify is to invest in mutual funds. A mutual fund is a company that makes investments, usually in stocks or bonds. You, the investor, purchase shares of the mutual fund. The mutual fund, in turn, uses the money you invest, together with money from other investors, to buy investments that it holds for the collective benefit of all of its investors. Most mutual funds invest in stocks, bonds, or a combination of stocks and bonds. The value of an investor’s holdings in the mutual fund will fluctuate with the combined value of the mutual fund's assets.
By pooling money and buying a variety of investments, mutual funds provide diversification and soften the impact of many of the risks we have discussed. Performance risk could mean that some companies held by a mutual fund will do badly and their stock price will go down. Fraud risk could mean that other companies held by the mutual fund will implode because of the connivance and shenanigans of management. But other companies held by the mutual fund may do well and offset the negative impact of the poor performers and the frauds. Some mutual funds, such as lifecycle funds, balanced funds and lifestyle funds, have conservative investment portfolios that include both stocks and bonds. Their investment strategies are intended to reduce the potential for major downswings in the value of your portfolio, although they also have less potential for large upswings.
Mutual funds come in two basic flavors: index and managed. Index funds hold baskets of investments that mimic stock market indexes, like the Standard & Poor’s 500 or the Nasdaq 100. Index funds perform pretty much in line with upswings and downswings in the index they mimic. Because they hold a predetermined mix of assets, the cost of running them is low and the management fees and expenses for these funds tend to be comparatively low. Low fees and expenses help the investor make more from the investment.
Managed mutual funds have human beings who select the investments made by the funds. Managed funds tend to have higher management fees and expenses, because of the need to compensate the human beings who select the investments, and pay other expenses such as research costs. Managed mutual funds have a wide range of performance levels. Some do very well, and some perform abysmally. Many are cyclical, doing well or poorly in line with the upswings and downswings of the assets in which they invest. (For example, some managed mutual funds focus on particular industries, and will rise and fall in value along with the fortunes of those industries.) On average, most managed mutual funds do not perform better than index funds or even as well. Thus, the case for the ordinary investor to invest in a managed mutual fund isn’t obvious, particularly considering the higher fees and expenses that managed funds tend to have. Index funds are a better place to start, with one exception: the lifecycle fund.
The lifecycle fund provides lifelong management of your money for you. It invests your money in a diversified portfolio including stocks, bonds and perhaps a little bit in money market funds. Then, as you grow older, it changes the mix of investments to gradually make the portfolio less risky. Changing your portfolio's investment mix toward the less risky is what people should do as they approach retirement (see our discussion of changing your portfolio's asset mix as you grow older). With a lifecycle fund, the fund managers do the investment strategizing for you, and are required to tell you what changes in asset mix they make over time. Lifecycle funds have “target dates,” which is the year at or near which its investors expect to retire. In that year, the fund managers will change their mix of assets to a relatively low risk allocation suitable for retirement. Most mutual fund companies offering lifecycle funds have several funds to choose from, each with a different target date. What you do is pick a fund with a target date at or near the year when you expect to retire, and invest in it.
Another form of packaged diversification is offered by an investment called an “exchange traded fund” or ETF. ETFs are similar in many ways to mutual funds, in that they hold a basket of stocks or bonds based on a market index. ETFs can bought and sold during the trading day, and their prices will fluctuate with changes in market conditions during the trading day. By contrast, a mutual fund can be bought or sold only after the close of trading in the stock markets (4:00 p.m., Eastern Time). It wil be priced at the value it has based on the closing market prices of the assets it holds. Thus, a mutual fund’s shares have only one price each day—the day-end price--while an ETF's price may constantly change.
An ETF owns a basket of investments usually consisting of stocks, although a few ETFs hold bonds. Thus, it provides diversification much like a mutual fund. An ETF can be bought or sold any time during the trading day (9:30 a.m. to 4:00 p.m., Eastern Time). In theory, its price should be equivalent to the value of its holdings at the moment of the purchase or sale. In other words, an ETF’s price will fluctuate as the price of its underlying stocks or bonds change.
On unusually volatile days, when market trading is fast and furious, the price of an ETF can actually deviate from the value of the underlying assets (because market pricing mechanisms can't always keep up on a really busy day). This won't matter to people who hold ETFs long term, which should be the strategy for ordinary investors. However, if you, as an ordinary investor, are going to buy or sell an ETF, try to avoid doing so on a volatile day in the stocks. The price you pay or receive may be too high or too low, depending on whether or not the price of the ETF has become de-linked from the prices of the underlying assets. For example, if the Dow Jones Industrial Average has fallen 200 or 300 points in a morning, you may be tempted to rush in and buy an ETF cheaply. Or, conversely, you may be tempted to sell an ETF you already own before it loses more value. Avoid temptation in either case. First, short term trading isn't a good idea for ordinary investors--it's easy for them to run up costs and expenses, while profits can be elusive. Second, the ETF you buy may be mispriced if market pricing mechanisms haven't kept pace with market activity, and you could pay too much to buy. Or the ETF you sell may be priced too low.
Unlike mutual funds, ETFs do not have actively managed portfolios. They currently are structured only to invest in a predetermined basket of investments. Sometimes, these predetermined baskets are quite narrow—that is, they might consist of stocks from one or a few industries, or they might consist of stocks from just one foreign country. Narrowly focused ETFs are not suitable for the ordinary investor. They do not offer much diversification. Their narrow focus is meant for people who want to speculate on a particular limited group of stocks. They are not appropriate for general retirement savings (unless you are a do-it-yourselfer who likes to spend lots of time researching and watching the stock market). The ordinary investor should, if interested in ETFs, stick to broadly based, well-diversified ETFs.
The ordinary investor will generally find it easier to start off investing in mutual funds. Investments can be made in a mutual fund in very small amounts (sometimes as small as $50 at a time), which makes them ideal for payroll deduction. For example, if you can afford to invest $50 per paycheck, consider having it sent automatically from your bank account to the mutual fund. This puts your savings program on auto-pilot, which is one of the smartest financial moves you can make. ETFs must be purchased through stockbrokers. To invest in them, you would have to open an account with a stock brokerage firm and pay commissions to purchase the ETFs. You may also incur another investment expense because you’ll have to buy the EFT at the “ask” price quoted in the market. Investments sold on open markets like stock exchanges typically have two prices: the “ask” price at which you buy, and the “bid” price at which you sell. The ask price will be higher than the bid price, which means that if you buy and then immediately sell, you will lose money. The difference between the two prices (called the “bid-ask spread”) is a cost of the investment (which you may pay in addition to a commission). The commission expenses and the bid-ask spread can make it rather expensive to invest small amounts in ETFs.
Also, the variety of mutual funds available is much greater than the variety of ETFs. ETFs do not have actively managed portfolios, and that means they have nothing like the lifecycle fund, which is an important investment for ordinary investors to consider.
As you become wealthier, ETFs may become worthwhile. They may offer tax advantages, allowing you to defer taxes on many capital gains until you sell the ETFs. Mutual funds, by contrast, generally require investors to pay taxes on the capital gains the funds receive even if those gains are not distributed to the investors. ETFs also tend to have low management fees in comparison to many mutual funds, an advantage that can compound significantly over time.
Our discussion of diversification continues in the next section, with a discussion of the need to change your asset mix as you grow older.