Welcome to class my friends, we have class today and tomorrow, with some extra credit coming after that.
Personal finance and investing advocates preach many terms. Perhaps none are as important as asset allocation and diversification. Today we’re going to talk about asset allocation and tomorrow I have a course on diversification.
For the sake of argument, let’s say you are 30 years old and just inherited $1 million from an unknown uncle. You are smart with money and aren’t going to waste it on a car, house, or vacation. It came to you in a check, so you have no idea how it was invest prior to receiving it. You want to invest all of it, but don’t know where to start. Bankers from every major firm have contacted you but before you meet with anyone, you want to learn a bit more about investing your money.
Rule #1 with investing is to not put all of your eggs in one basket. This means keeping your money in different asset classes to meet your needs. Your needs depend on a variety of factors, most importantly, what you intend to do with the money someday. We’ll discuss how that will vary in a moment, but first let me introduce you to the common asset classes:
Stocks – Also referred to as equities, this is the most common investment vehicle in the world. They carry a great amount of risk (the current market shows that), but over time they offer the greatest returns. Historical averages of stock investing vary between 6-12% depending on what stocks you are invested in. There is no guaranteed return with stocks, but you make money through dividends (distribution of profits by a company) and by the increase in price of the stock over time. The most common vehicle used to invest in stocks is the mutual fund.
Bonds – These are often referred to as fixed-income because there is a contract associated with each bond guaranteeing a fixed return over time. You might by a government bond for $10,000 and it will pay you back over time at a set rate (for example 5%) Bonds are considered less risky that stocks, but still carry their own risk. If the issuer defaults (think WaMu bankruptcy), you may or may not get all of your money back. Less risky bonds would be the types issued by governments to raise money. Few governments ever default. The return is often less than stocks, but so is the burden of risk. Bond mutual funds also exist.
Cash & Equivalents – Generally speaking, people keep in cash the money they expect to use in the near future. If you are planning to buy a $50,000 vehicle next year, you might sell some stocks or bonds and keep it in cash. This isn’t $20s in a suitcase, but rather accounts like a money market or certificate of deposit. Many mutual funds keep a certain amount of money in cash, giving them quick access to money when a great investment opportunity comes to mind.
These are the three most common asset classes for investments. Asset allocation is all about finding the right balance between them to meet your needs. A 25 year old with no intention of touching the money for 10 + years would put all their money into stocks because it has the best return, and 7-10 years is long enough to ride out the worst of stock markets. If you’re setting aside a chunk to pay for your kid’s Ivy League education, you might start off in stocks while they are younger. In the last few years approaching college age, you would move that money into bonds, perhaps 60% bonds / 40% stocks at age 15, 70% bonds / 30% stocks at 16, etc. This limits your exposure to an economic downturn (like our current situation) thus preserving the balance of the portfolio. The same applies to someone near retirement. The closer you are to retirement, the less you want to grow your money. You are much more interested in protecting your money and having access to it.
There are many other asset classes beyond stocks, bonds, and cash. Some are fairly easy to get into, while others require you to have many millions in order to play:
Private Equity – Private equity is an investment company that invests your money in private companies. So the private equity group might pool your millions with other millions to buy a part of, all of, or start a company. The most well known private equity firm is perhaps Cerebus Capital Management, who bought Chrysler. Private equity can yield great rewards, but it carries high risk and your money can be locked up for a while.
Venture Capital – Similar to private equity, VCs are usually after funding new companies. YouTube and Google are among the most famous receivers of VC financing. The cost to play is again high, but the returns… well, Google has done well.
Commodities – Previously a tough game to get into, the emergencies of mutual funds and other investments that act like mutual funds mean you can allocate some assets into commodities for just a few hundred bucks. Some vehicles specialize in just a commodity, like oil, natural gas, coffee, or gold. Others look to invest in all commodities. Most people would never make this more than 5% of their portfolio, and I wouldn’t consider this asset class unless I had $1 million like in the example we’re using.
Real Estate – The elephant in the room is real estate. Previously a great investment, but people overextended themselves. As an asset class for your portfolio outside of just your primary residence, you also don’t want too much money invested in real estate. Fortunately, there are investment vehicles called REITs (Real Estate Investment Trusts) which allow you to get into real estate without buying an entire property. If you buy into a REIT, you are buying into a company that invests in real estate. They might buy foreclosures, flip houses, rent apartments, office space, engage in property management, or a combination of these options. You can buy into REITs like you would a mutual fund, and as a minor asset class, real estate offers a great way to protect yourself from the market swings of stocks. Not recommended is directly buying property and doing it yourself, but this is also an option.
Hedge Funds – Another well known asset class is hedge funds. They can be grouped with stocks and bonds, but their goal to always have a return no matter what the market, and the cost of entry, makes them a separate class. Hedge funds seek to make money no matter what. So when you are looking at allocating your assets to limit your direct exposure to the stock market, hedge funds should be considered. Not all funds were highly leveraged buyers of sub-prime mortgages, many only buy bonds and Fortune 500 companies but in a combination that is won’t swing with the market. The cost of getting in can be high. I’ve never seen anything below $100,000, and $1 million or more is normal. Like the other asset classes, hedge funds should not be your primary investment, but they are good.
There are still others, but we must move on. The game of asset allocation is finding the right balance among all of these different classes. There is no secret, and financial advisors will differ on how much of your investment should go into a specific bucket. The whole idea is managing risk, and your risk profile is unique to you. Your financial advisor should only do two things for you: the first is to help you identify your risk profile, and the second is to actually implement whatever YOU say you want your investments to be. You decide how much money goes where, and you can only make that decision if you fully understand everything you’re invested in. Educate yourself on the asset classes, determine your goals, and of course don’t ever go with an advisor that works on commission.
So you decided you want to put your money in mostly stocks and bonds. Sounds good, but which stocks and bonds? That my friends is diversification, and we’ll discuss that tomorrow.
 By The Weakonomist |
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