Follow these three core investing concepts to take the guesswork out of your investments and meet your goals!
Turn on your favorite investing show on TV or click through to just about any blog and you’d get the idea that investing is all about the ‘what’. Find that perfect stock pick or the next big thing and watch your nest egg grow.
The truth is that meeting your financial goals is much more about the ‘how’ of investing, the core investing concepts that guide everything else.
These are the fundamental ideas in investing that you need to start with, that foundation on which every investing plan needs to be built. These are the ideas that really make money in investments. It’s not about picking the best stocks or about getting a hot tip from some pundit on TV.
Most people don’t start with these core investing ideas. They jump straight to the ‘what’ of investing by turning on the TV and looking for a hot stock tip or they go to their online brokerage account to see what some analyst is recommending.
Because investors don’t know how to invest, they end up chasing stocks and making bad investments. Money manager BlackRock recently released its study on investor returns for the 20 years through 2015.
Over the last two decades, the stock market has returned an average 8.2% annually and bonds have provided a 5.3% annual return. Not too bad against inflation of 2.2% a year. Even the price of oil which nose-dived in 2014 and the return on housing prices (we all remember what happened there in 2008) each provided a 3.3% annual return over the last 20 years.
How did the average investor do over this period? The average investor earned just 2.1% annually over the last two decades.
That means the average investor actually lost money due to inflation. That’s a miserable outcome and a big reason why one-in-three families don’t have anything saved for retirement. They see their investing account losing money after inflation and just get fed up. They take their money out and think investing is a rigged game.
This isn’t the only study showing the sad state of investing returns. DALBAR research updates their investor returns survey regularly and it shows the exact same thing.
Focusing on the ‘what’ of investing instead of first understanding how to invest is just setting yourself up for a nightmare. Individual investments will change constantly, you’ll lose thousands to investing fees and will end up buying-high and selling-low.
We’ll talk about three core investing concepts in this lesson. Core investing ideas that will teach you exactly how to invest in a plan customized for your needs. Understand these three critical investing ideas and the ‘what’ of investing won’t seem nearly as important.
Within this lesson, we’ll talk about:
- What is diversification, how it will boost your returns and keep you from freaking out over your investments
- What is liquidity and how it puts most investor portfolios on a roller-coaster
- How to match your investments to your own personal needs
This is one of my favorite lessons in investing because it’s so important, so let’s get started.
Why Diversification is the Most Important Concept for Investors
You might have heard about diversification. It’s a popular investing concept but one that very few investors actually use correctly. In fact, I’d say it is the most underappreciated tool for the average investor.
Let’s look at a chart of two investors. The grey line is the total return on stocks in the S&P 500 over the decade through 2015. An investor would have doubled their money over the period investing exclusively in stocks, not bad.
But that investor doesn’t exist, do they.
The average investor, the red line, freaks out when stocks tumble and sells at a loss. They lose sleep for the next year wondering how they will ever pay for retirement. Finally after the stock market has started rebounding, they jump back in but the damage is already done. They’ve missed out on a lot of the gains and are stuck with a miserable return over the decade.
The diversified investor, the green line, has a mix of asset classes and never sees their investments obliterated in a stock market crash. The diversified investor’s portfolio might take a hit when stocks plunge but the 15% loss on a stock and bond portfolio is nothing to worry about. They sleep well at night knowing their investments can recover from this minor hiccup.
And it pays off. The diversified investor benefits from the full rebound in stocks and books a solid return over the decade.
What is Investment Diversification?
So what is diversification and how can you use it to keep from freaking out?
Diversification is just a long word for investing in different types of investments. We’re not talking about stocks of different companies but different investments altogether like stocks, bonds, real estate and even some alternative investments.
These different types of investments are called asset classes. Asset classes differ from each other on how they react to the economy and other forces. Inflation isn’t so bad for stocks or real estate but it will hold back the value of bonds. Higher interest rates aren’t so bad for stocks but will hit real estate prices. A struggling economy and falling interest rates may cause stocks to tumble while bonds increase in value.
Holding investments in different asset classes, i.e. owning stocks, bonds and real estate, means that you benefit from some investments rising even while others are falling. Your bond investments are protecting you from losses even as the stock market plunges.
What are the Asset Classes for Diversification?
Let’s take a look at the different asset classes and different investments within each asset class. Remember, the idea is that you get safety by investing in a broad mix of asset classes so the value of some investments will be rising even if others are falling.
This idea of diversification works within each asset class as well. Within each asset class, stocks for example, there are different types of investments that react differently to the economy. If you were to only invest in stocks of internet companies…well, you might remember what happened when the internet bubble burst in 2000.
Invest in a diversified portfolio of stocks including financial companies, utilities, consumer goods and other sectors and you won’t see your stock portfolio smashed when one group takes a hit.
Stocks as an Asset Class
Stocks are an ownership in a company, you are actually investing in the future of that company. You get a share in the earnings and cash flow but the risk is that there won’t be much of these to go around.
Since stocks are an ownership of a company’s future, they do well when it looks like that future will be brighter. The stock market will generally follow the economy shown with the change in real gross domestic product (GDP) in the chart below, either higher or lower.
All the things that signal a healthy economy like low unemployment, modestly rising wages and stable inflation are all positive for stock prices. It may seem obvious but it’s going to be important when we look at the other asset classes.
Looking within stocks, we have groups that react differently to the economy.
The stock market is separated into sectors and industries within those sectors. Sectors are broad areas of business like utilities, technology and healthcare. Within each sector are smaller industries which are groups of companies with similar products or customers.
The nine sectors of the stock market are:
- Technology is comprised of companies that sell computer equipment, software and internet companies. Industries and companies in technology generally have fast sales growth when economic growth is strong but will see sales tumble during a recession.
- Consumer Discretionary is comprised of companies that sell things people buy but that they may not necessarily need to live including apparel and automobiles. Some of these companies may have very strong customer loyalty that helps them keep sales growing even during a recession but there is still some worry when consumers don’t have the money to spend as much.
- Consumer Staples are companies that sell things people need to survive like food, beverages and household products. This is one of the safest sectors of stocks because sales do not generally fall when the economy tumbles. People need to eat even in a recession so they’ll forego spending on discretionary products rather than staples.
- Energy is comprised of companies that explore and produce oil & gas, companies that refine it into gasoline or other products, companies that generate alternative energy sources and others that sell equipment or services. While oil & gas is something we all need even during a recession, stock prices in the sector still rise and fall with the economy because business customers might not need as much energy resources and the market price for oil & gas may drop.
- Financials include banks, insurance companies and investment firms. These companies are generally most exposed to changes in interest rates because it’s how many of them make money. Falling interest rates might be good for other sectors when the companies can borrow cheaply but financials are hurt because they won’t be collecting as much interest payments.
- Health Care includes drug makers, health care providers and services, biotechnology and health care equipment. Sales for some of these industries like providers and drug makers might be fairly stable while other groups within the sector will follow the business cycle more closely. The health care sector will benefit from an aging population over the next few decades as people use more services. By comparison, other sectors like consumer discretionary and industrials might not benefit from an aging population as older consumers leave the workforce and see their budgets shrink.
- Materials is comprised of industries in chemicals, construction materials, metals & mining and paper products. These are the basic inputs other companies need for raw materials to their products. When the demand for those raw materials drops because of a weak economy then the stocks of materials companies drop in tandem.
- Industrials is a very broad sector encompassing everything from aerospace & defense companies to machinery, infrastructure and commercial services. Stocks of industrial companies do best during the first stages of an economic recovery because sales are increasing rapidly after falling hard during a recession.
- Utilities include electric, gas, water and other power providers. Some of these companies are regulated by the government with limits on how much they can charge but protecting them from competition. People need power and water in good times and bad so these companies are generally the least affected by a recession.
Fidelity Investments offers a nice graphic on how each sector tends to perform during different stages of the business cycle or the economy. During a recession, sectors with more sales stability like staples, health care and utilities tend to do well. In the early innings of an economic recovery, discretionary, industrials and technology do better because sales for companies in these sectors are increasing quickly after they dropped off during the recession.
When we look at the different sectors and how they perform during different stages of the economy, I’m not suggesting that you need to change your investments depending on the economy. That kind of market timing is difficult if not a waste of time for most investors.
What I am saying is that you need to have investments in different sectors so that when the companies in one sector are performing poorly, say technology companies during a recession, then your investments in utilities and consumer staples will help support your portfolio.
Within each sector are industries comprised of companies that sell similar products or services and the companies within each industry may react differently to the economy. For example, in the health care sector we find pharmaceutical companies as well as biotechnology, managed health care and medical equipment. Sales for managed health care companies may be more stable since people need their services constantly while sales for medical equipment might rise and fall depending on hospital budgets.
You will definitely need to plan the percentage of your stock investments in the different sectors, i.e. planning how much you want to invest in each sector according to your goals. You may not necessarily need to go as far as separating your investments by industry. For most investors, separating your stock investments by sectors will give you the diversification you need within stocks.
One further level of diversification within stocks is the difference between stocks of U.S. companies and those of foreign companies. While the economies of different countries will generally rise and fall closely together, it’s not always the case and they definitely won’t do so exactly.
For example, while the United States saw its worst recession in nearly a century when the housing bubble burst many countries bounced back quickly from the 2008 global recession. The economies of developing countries in Latin America and Asia rebounded in 2009 and 2010 on higher prices for metals and oil.
When the bursting of the internet bubble forced the U.S. into a recession in 2000, the countries of the European Union continued to do well with growth of between 2.5% and 5% over the next several years.
The idea again is that when we start looking at different investments to put in our portfolio, we make sure we have different asset classes and different investments within each asset class. Investing across the asset classes and in different segments within each asset class smooths your returns and reduces your overall risk.
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Bonds as an Asset Class
Bonds or fixed-income investments are loans to governments, corporations or even individuals. These loans can be for as little as a year and as long as several decades. The interest rate on the loans is set by a lender depending on a range of factors like collateral the borrower has and past borrowing, just like how your credit report and score affects the rate you get on loans.
When a bond is issued, whether it is a government or corporate bond, it is assigned a rating according to the risk that the issuer will not be able to make payments. That rank goes from AAA which is a rating even the U.S. government has lost to C and D ratings where the company might already be in default.
Bonds are issued for one-year all the way up to 30-years and beyond. Bonds issued for just a few years offer lower interest rates because the payoff date is sooner and investors face less risk that rates will change or that the issuer will default. Bonds issued for 30-year payoffs must offer a much higher rate because a lot can happen in three decades.
Most people think of stocks when they talk about investments but the global bond market, all these loans to governments and corporations, is much larger. There are about $70 trillion worth of stock traded on the world’s stock exchanges but more than $100 trillion in bonds traded.
There’s a lot to like about investing in bonds.
- As debt obligations, they get paid out before stocks. If a company bankrupts, stockholders get wiped out while bond investors will get something back on their investment.
- Just like any loan, bonds pay interest on a regular basis. Most bonds return money to investors twice a year though one new investment returns cash monthly. Most bonds pay only the interest to investors until the payoff date and then they return the face value of the debt.
- Bonds can be extremely safe, from the so-called risk-free investment in U.S. Treasuries to investment grade bonds of billion dollar companies with just a tenth of a percent defaulting on average each year. That means stable returns versus a stock market that regularly loses double-digits.
As debt obligations, bond prices and returns behave differently compared to stocks and that’s where we get the power of diversification. Since the attractiveness of bonds is partly in the interest rate on the loan, bonds’ prices rise and fall along with interest rates.
If the economy starts to wobble, the central bank may decide to cut interest rates to spur lending and economic growth. Stocks will tumble at the first sign of a recession but bonds hold their value relatively well and can actually increase in value as interest rates decrease.
We won’t go into the specifics of bond pricing here, I’m putting together a complete video course on bond investing. I think a graph of the total return on corporate bonds (in black) versus stocks (in red) does a good job of demonstrating the need for bond investments.
There are three points that should be clear from the chart. First is that an investment in corporate bonds have actually beaten stocks over the past two decades. That’s amazing in itself.
Second, the return on bonds is much smoother than that of stocks. During the two stock market crashes over the last 20 years, the return on bonds barely budged. Bond investors might have seen a quick dip in values but it was nothing like the 50% shipwreck in stocks and it wasn’t long before bond investments were moving higher.
The last point is difficult to see because the bottom chart of economic growth is cumulative. You don’t quite get a sense of the drop in the economy during 2000 or 2008 but you can clearly see the effect on stock prices. Stocks follow the economy, sometimes to places we don’t like to see.
The reason why we even see a blip in bond values when the economy tumbles is because the bond group here includes those of weaker companies with a higher chance of bankruptcy during recession. Even with those weaker companies, the entire group of bonds barely sniffles when the economy catches a cold.
So now that you are ready to rush out and put all your money in bonds…let’s look at some of the different bond investments. Don’t rush out and put all your money in bonds, by the way. That would be just as bad as having it all in stocks and it’s not the point we’re getting to here, right?
Government bonds are generally thought to be the safest because they are backed by the taxing authority of the country. Even governments as large as the United States needs to borrow money, actually the U.S. borrows more than any other country and owes $20 trillion dollars.
Since nobody believes the U.S. government will default on its bonds, it can borrow at very cheap rates. Compare that with a country like Venezuela which most investors think will default on its debt soon which is paying rates of 10% and higher.
The upside to a lower interest rate on U.S. government bonds is that the interest you collect is not taxed on state income taxes but is on federal taxes.
One step down from bonds issued by a federal government are those issued by local governments, called municipal bonds. These loans go to fund highways and other infrastructure, schools and other public programs.
Just as with the other bonds we’ll look at, local governments are assigned a rating by one of the three agencies depending on its financial strength. This rating will help determine the interest rate that must be offered to attract investors to fund the loan.
While the risk in some areas is higher, it’s important to remember that overall default rates in municipal bonds has been less than a twentieth of a percent over the last four decades so these are generally very safe investments.
As an added bonus to investing in municipal bonds, interest payments you receive are also tax-free for your federal income taxes and many offer tax-free benefits from state taxes as well.
I’ve included a table here comparing the rates offered on ten-year bonds from different issuers and ratings. You can see that municipal bonds offer a slightly lower rate than even Treasuries because of those federal tax-free payments.
Remember that bonds are issued for a range of years and given a range of ratings so the interest rates offered are much wider than just shown here.
Corporate bonds are the next rung down on risk but that confuses the fact that there is a huge difference in risk between the strongest companies and the weakest. The rate on ten-year bonds of the strongest companies, those with a AAA-rating, pay just 2.9% annually. That’s not much more than the 2.4% rate offered by the United States government.
By comparison, rates offered on riskier companies pay an average of 7.7% annually but default rates are as high as 5% each year.
I’m putting together a complete bond investing video course but if you want to learn more about investing in the safety of bonds, check out Step-by-Step Bond Investing: A Beginner’s Guide to Investing in the Bond Market. I show you how to ditch the stock market game for safety and cash flow in bonds. Learn why most investors are dangerously under-invested in bonds and how the asset class can help you reach your goals.
There’s one final type of bond investment though many don’t consider it in the same league as the other fixed income investments.
Peer lending is a loan issued to an individual rather than a government or company. These loan investments share the same fundamental traits as bonds but differ on some important points:
- Peer loans are unsecured meaning the borrower hasn’t put up collateral. Whereas bond investors of a bankrupt company might get something back as the company sells its assets, peer loan investors will get nothing if the borrower defaults.
- Peer loans pay interest and return of investment each month. Traditional bonds pay only the interest and then a lump sum at the end of the bond’s maturity.
- Peer loans are less formally regulated compared to bonds which means there is a higher chance of fraud.
Despite some of the risks in peer lending, I think it’s a huge opportunity for investors and have more than $20,000 of my own money in loans on Lending Club.
Loans are assigned a rating according to the borrower’s credit history and offer returns of between 5% to 15% and more. I interviewed one peer lending investor that has averaged 12% annual returns for nearly a decade and I’ve averaged returns of 9% even on my portfolio of less risky loans.
Peer loans offer all the safety of bonds but an opportunity for returns that are comparable with stocks. Since they are debt obligations, peer loan investments won’t rise and fall as much as stocks during a recession. That’s the safety aspect but because there is more risk than a traditional bond, you get returns that are two and three times as much as you’ll get in other bonds.
I go into detail on peer lending including the exact strategy I use to increase returns and lower defaults in the bond investing course. It’s not necessarily something you have to invest in to get the diversification you need but it’s a great new opportunity for investors.
Real Estate as an Asset Class
No other asset class has created as much family wealth as real estate. For thousands of years, property has been passed down through generations to accumulate huge fortunes. Less than 170 years ago, you had to own property to vote in the United States.
While the debate rages whether your own home can be considered an investment, there is no argument that owning rental property is a great source of cash flow and return.
In fact, there really isn’t even a question of the better investment between stocks and real estate. Check out the graphic comparing returns on the S&P 500 versus an index of commercial real estate over the past 40 years.
Stocks have returned an average 8.2% annually over the four decades to 2017. That’s not bad and amounts to a 20-fold increase in an initial investment. U.S. real estate has beaten it though with an annualized 12.7% return, growing an initial investment by 122-times!
Just like the market beating returns in bonds, you shouldn’t rush out to put all your money in real estate. The real estate index above lost 68% of its value over two years to February 2009, much more than even the loss on stocks.
Combining all the asset classes we’re talking about gives you the opportunity for strong returns while protecting you from the horrific losses during crashes.
Adding real estate to your investment portfolio diversifies your wealth and smooths out the risk in a stock portfolio because real estate isn’t affected by the same economic characteristics.
- Property is a real asset so holds its value against inflation. While lower inflation doesn’t usually hurt stocks, faster inflation can hurt companies because they aren’t able to pass along higher costs to customers.
- Some property types are less affected by the economy. People will always need a place to stay, giving apartments a constant demand. Even during a deep recession, demand for real estate can be more consistent than stock prices.
- Changing interest rates affect real estate prices differently than stocks. Higher rates depress real estate prices because of borrowing costs but usually happens during good economic times and strong demand for property.
As the man said, “real estate is the only investment they aren’t making anymore.” Companies can issue more stock, diluting earlier investors and new bonds are always being issued. Even other real assets like gold and silver are constantly being mined for new supply.
As with the other asset classes, I’m putting together an entire course for real estate investing including how to find and value property.
There are three ways to invest in real estate, through direct purchase of property, buying real estate investment trusts (REITs) and through real estate crowdfunding.
Direct Real Estate Investment
Buying property is what most people think of real estate investing. It has its advantages but also its limitations.
Just as buying the stocks of companies within one sector leaves you exposed to risks in that part of the economy, you need to spread your real estate investment risks beyond just one property. A lot of investors own a couple of rental houses or apartment buildings and think they are diversifying their wealth.
Instead of investing, this is really just earning a return on property management with some gains on building appreciation. True real estate investing means buying different property types and in different locations to protect yourself from property-specific risks.
Considering there are five property types (office, industrial, storage, residential and leisure) and you need properties in at least a few different regions for real diversification, this is a problem for most investors.
I’m not saying direct real estate purchase can’t be a part of your diversified portfolio but understand that unless you’re able to buy 10 or more properties, you are adding a lot of risk to your overall portfolio.
REIT Investment for Real Diversification
One way Main Street investors can get that diversification in real estate without putting down a few million is through real estate investment trusts (REITs). These are companies that buy and manage commercial real estate and issue shares on the stock market. Some companies own specific property types in different regions while others hold a broader mix of properties.
REITs are set up under a special tax law that lets them avoid paying corporate taxes if more than 90% of income is distributed to investors. That means REITs pay great dividends and are an efficient way to hold real estate investments, foregoing the double taxation that investors usually get with other stocks.
You can buy shares of REITs for less than $10 to get instant diversification within real estate. The downside is that you have almost no control over the properties and cash flow depends on what is distributed by the company.
I’ve graphed the return on the Vanguard REIT ETF (VNQ), a fund that holds shares in the largest REIT companies, to use as a proxy for the investment against the S&P 500. Return data is only available since 2005 but shows market-beating real estate returns hold up even with this kind of indirect investment.
Even on the nail-biting drop in property values in 2008, REITs have beaten stocks over the last 12 years with an 8.8% annual return versus just 5.8% annualized for stocks.
You can invest in individual REITs that own a specific type of property or in a fund that holds REITs to get broad exposure to the investment. I own both the Vanguard REIT ETF and several individual companies that own healthcare, residential and storage properties.
Crowdfunding Real Estate to the Rescue
There’s still one last way to invest in real estate to add returns and diversification to your portfolio.
Real estate crowdfunding is like a mix of direct real estate investment and buying shares of REITs. Special crowdfunding platforms are set up to accept real estate projects looking for investors. Real estate developers contact the online platforms to get their project listed and the platform staff makes sure the project complies with regulations and checks the soundness of the investment.
If the project passes this analysis, it is listed on the platform for investors. I did a detailed review of real estate crowdfunding as an investment and found some pros and cons of the new asset class.
- Investors can start with as little as $5,000 on platforms like RealtyShares to get exposure to multiple property types and locations.
- Returns are generally higher than with REITs though data on historical returns is limited
- Debt and equity investments are available with most investments maturing in less than five years
- No management needed since the developer directly manages the property
- Investors still need to do some due diligence and analysis on the investment and the developer. This could mean hours of research for each potential property investment.
I have invested in residential property but now only own a few rental houses because of the headaches involved with property management. I own a portfolio of REITs as well as invest in real estate crowdfunding. I found the mix of REITs plus crowdfunding gives me higher returns but makes it easier to get diversification across real estate and without the constant hassle of management.
Alternative investments as an Asset Class
There is one final asset class we’ll talk about but it may not even be something you need to worry about for your portfolio. This asset class is called ‘alternative’ investments because they share characteristics that are very much different from the norm most investors know in stocks, bonds and real estate.
- These alternative investments have much longer holding periods, some may even lock your investment up for a number of years before you are able to sell.
- There is not a marketplace for these investments as there is with stocks or bonds so you have to negotiate a purchase or sell directly with another investor
- Some of these investments involve substantial risk and the probability of total loss in individual investments
- Some of the investments involve unique regulatory oversight and only allow certain investors to participate
There are some benefits to alternative investments. Many offer the potential for returns unheard of in stock investing, upwards of 27% for startup investing. They also offer diversification benefits because the investments react differently to the economy.
We’ll outline three types of alternative investments.
Private Equity firms are investment management companies that buy established companies to generate higher profits on better management. Often, this means buying out existing shareholders and breaking up the company or leveraging it by borrowing to cash out investors.
Private equity firms are able to use billions in investment to take a company private and then squeeze every bit of profitability out of it. Investments with the firms are often locked up for at least three to five years while the management works on turning a company around. Average private equity returns over the 30 years through 2015 were 13.4% on an annual basis.
Hedge Funds are another type of investment firm that uses complex investing strategies to beat the stock market. Some hedge funds try to pick stocks in a way that will remove market risk from the portfolio, a neutral hedging strategy, while others try to make higher returns buying an investment then selling options against it.
The wide range of hedge fund strategies makes it difficult to point to an average return across the entire group but a common index of funds has returned 10% annually over 26 years through 2016.
Both hedge funds and private equity charge high fees, usually 2% of your total investment plus 20% of profits each year. Both hedge fund and private equity are also off-limits for most investors.
The Securities & Exchange Commission (SEC) prohibits non-accredited investors, those with less than a million in net worth or under $200,000 annual income, from investing with private equity firms and hedge funds.
One alternative investment type that is open to Main Street investors is startup investing through equity crowdfunding. In the past, only venture capital and angel investors could invest in startups before they were available on the stock exchanges.
This changed in May 2016 when the SEC passed a law allowing regular investors access to equity crowdfunding platforms. These websites work just like real estate crowdfunding platforms, connecting startup companies with funding needs and investors looking for higher returns.
I’ve worked as an analyst and a director for venture capital firms, analyzing startup deals, and can tell you that it is nothing like you’ve seen in stock investing. A study by Willamette University shows returns on portfolios of startup companies have averaged 27% a year but the fact that half of the individual investments return nothing or less than the original investment makes this a high risk, high return opportunity.
In startup investing, you are buying an ownership share of a company that doesn’t offer stock in the market. These startups are usually spectacularly unprofitable with few sales and lots of expenses. Some startups may not even have a finished product yet.
But the idea is that every company started as a startup at one point. Facebook accepted its first outside investor, Peter Thiel, with a $500,000 investment in 2004. Most of us weren’t able to invest in Facebook until it went public in 2012.
By then, Thiel had already made $1.7 billion on his investment for a 340,000% return.
I spend more than 40 hours researching startup investing deals for private investors and there is a world of information to analyze. I’m putting together an entire course on startup investing with the exact process I use to find the best deals for venture capital clients.
While I believe in the potential for great returns in startup investing, it’s not altogether necessary for most investors. These last investments are called ‘alternative’ for a reason and they’re not for everyone. There are some diversification benefits and certainly an upside on returns but most investors will be just fine with a portfolio of stocks, bonds and real estate.
Why Do Investors Avoid Diversification?
If diversification is such an important investing concept, why don’t all investors diversify their portfolio? There are three reasons why the average investor is so horribly under-diversified and why it ends up costing them their investing goals.
First, investors love to chase stocks. There is something of a lottery-ticket appeal in stock investing. The financial press loves to talk about stocks that have soared thousands of percent, they even have a name for it, a ten-bagger is a stock that has jumped ten-times its initial price.
Against the slow-and-steady 5% annual return on bonds, that 8% return on stocks seems like the difference between vacationing in Paris, France versus Paris, Texas.
Turn to your favorite investing show or blog and the only thing you’ll hear is where are stocks going. You hear almost nothing about the other asset classes or how to invest, so it’s natural that investors think it’s all about stocks and chase those high returns.
Another reason is that most investors have less than a few thousand a year to put to work. Invest $3,000 a year in bonds and you might see gains of just $150 on that 5% annual return. Even investing it all in stocks is only a gain of $240 on an 8% return. Investors look at this short-term picture and think they have to put everything in stocks just to get anywhere.
They miss the safety of diversification and end up watching their investments melt in a stock market crash.
Finally, investors don’t diversify their portfolio because diversification will mean sacrificing the highest return for safety. Remember the hypothetical all-stocks investor in the ten-year chart above? Just keeping their money in stocks meant a 100% return over the decade versus about an 85% return for the diversified investor.
The fact is that adding in safer investments in other asset classes will lower your total return. Of course, we know that hypothetical all-stock investor doesn’t exist. The real stock investor ends up panicking and selling their stocks for a dismal return.
So while diversifying your portfolio with a mix of asset classes will lower your potential return compared to an all-stock portfolio, like some kind of investing magic, you’ll still earn more than the average investor that only puts their money in stocks.
How to Diversify your Investment Portfolio
I’ll talk about matching your investments with your personal finance needs later in the lesson. Basically, you are going to be assigning a percentage of your total investable wealth to each asset class. Say you’ve got $10,000 to invest then you might find you need 50% or $5,000 in stocks, 30% or $3,000 in bonds, 15% or $1,500 in real estate and the remaining 5% or $500 in other assets.
This is going to help protect you from the big ups and downs in any one asset class like stocks, just this higher-level planning. You also want to break your investment in each asset class into percentages as well.
For example, with that $5,000 invested in stocks, you might find you want 40% or $2,000 in relatively saver sectors like utilities, consumer staples and healthcare while investing the other 60% across the remaining sectors.
For your investment in bonds, you’ll want to hold some money in the safest and highest quality corporate bonds but might want to take advantage of tax-savings with some money in municipal bonds or a little higher return with some high-yield bonds.
It might seem like a lot of work but it is extremely important that you spread your investments around like this. You will only have to do it once and then adjust the percentages every few years, so it’s very easy to maintain once you’ve got it set.
We’ll talk about exactly how to choose the right amount in each asset class later in the lesson.
Liquidity: The Core Investment Concept Nobody Understands
While diversification is popular among investors, even if almost nobody does it right, most investors don’t understand liquidity at all.
That’s too bad because not understanding this simple investing concept causes big problems and is a leading reason most people fail at saving enough for retirement. A study by Bankrate found that more than 30 million Americans take money out of their retirement savings each year for unexpected expenses.
They lose the ability to make money on those funds. Just $2,000 can grow to almost ten grand over 20 years. They also may have to pay income taxes and a 10% penalty on their own money if they take it out of a tax-advantaged retirement account.
On top of all this, taking money out of your long-term investments just makes it easier to raid your nest egg later. It’s a slippery slope and America is falling head first.
This all gets to the idea of liquidity, what is it and what does it mean for your investments.
What is Liquidity?
Think of the word liquidity, the word liquid, and think of it as the flow of your money. How much comes in and how much goes out. It also includes those hard to measure sums of money that go out unexpectedly, the car breaking down and the emergency medical bills.
Liquidity is your need for cash each month, both for planned and unplanned expenses.
Why does Liquidity cause so Many Problems?
Of course, it’s difficult to budget for those unexpected problems. You don’t know when the car is going to break down or when the dentist is finally going to say that your kid needs braces. I love it when I hear someone say, “Expect the unexpected.” Have you ever heard anything so ridiculous in your life? If you COULD expect it then it wouldn’t be unexpected!
There are three reasons why the need for quick cash causes investors so many problems, some are within your control while others are not.
- Not budgeting infrequent expenses, those bills that come due every few months or each year that you forget to save for in your monthly budget.
- Forgetting to budget for life goals or big family expenses like an annual vacation.
- Emergency needs that couldn’t be planned for like medical expenses, accidents and repairs.
How to Prepare for Emergency Cash Needs
As hard as it may seem to prepare for emergency cash needs, you can beat the problem of constantly dipping into your investments. You might not be able to expect the unexpected, but you can budget for it.
- First, you have to have enough insurance. I know it sucks paying into every month if you don’t think you’ll use it but you don’t want to play that lottery game. A bad medical expense can wipe out decades of saving. If you opt for a high deductible policy, you can qualify for one of my favorite tax-free investment options to help pay medical expenses.
- If you have insurance then you know how much your deductible will be if something happens, that money you’ll have to pay for medical services. Budget for a few of these each year and put that money in your emergency fund.
- Budget for those infrequent bills that come due every few months or annually. This means gathering up your credit card statements for the last year and seeing where your money went. Building your budget by looking at actual expenses is so much more effective than just trying to list out your expenses off the top of your head.
- Don’t forget to budget for fun stuff like vacations and those things on your bucket list. Nobody wants to be a millionaire in retirement if it means spending 30 years being miserable and living off Ramen noodles.
- You can budget for repairs and other unexpected expenses. Check online to see the average amount paid on car repairs per year, it’s $914 for tires and repairs for all cars but varies by type of car. If you own your home, don’t forget to save for home repairs as well.
So you’ve built a rock-solid budget that includes emergency expenses, vacations and infrequent bills…the important point here is to put that money each month into an emergency fund. It does no good budgeting for these things if you get to the end of the month, see extra cash in your savings account and then spend it.
This is where your emergency fund comes in. This is money set aside that will keep you from dipping into your long-term investments. Not only does your emergency fund help pay for unexpected expenses but it can also help pay the bills if you lose your income suddenly.
The old school of thought was to have from three months to six months of your expenses in an emergency fund. This would mean taking all that money you’re budgeting for unexpected costs and putting it into your fund until it equals up to six months of your expenses. If you spend $4,000 a month then you would build your emergency fund up to at least $12,000 but not more than $24,000 and then put anything after that in investments.
The rule of thumb isn’t too bad but it’s kind of a guess. A better approach would be to add up all the ‘unexpected’ things for which you are budgeting, those medical expenses, repairs and other bills and then add two or three months of expenses. This means even in the worst case scenario where you lose your income and have to pay for a few unexpected expenses, you should still have enough to keep from raiding your nest egg.
So where do you put your emergency fund?
This is money that you absolutely need available when you need it. You can’t have it in stocks because they can drop in value quickly and you might not have time to let the market rebound before you need the money. Emergency fund money has to be in the safest of investments.
Now these safest of investments don’t offer much return. It’s going to suck seeing your money sitting there, barely beating inflation, but that’s the price of financial security.
Try this strategy to invest your emergency fund money but still keep it safe:
- A third of your emergency fund should be in money market funds that you can access immediately. Rates on these are about half a percent but still higher than a savings account.
- Another third of the fund can be invested in government bonds that expire within six months to a year. These pay just under 1% annually and you can continuously buy more with the money on maturing bonds.
- The remaining third of your emergency fund can be invested in a bond exchange traded fund (ETF) that holds high-quality bonds. The iShares Core US Aggregate Bond Fund (AGG) has returned 3.1% annually over the past decade.
This strategy of budgeting and saving an emergency fund should help keep you from having to dip into your retirement investments. In those extremely rare emergencies where your emergency fund doesn’t cut it, take money out of your bond portfolio first.
Bond values don’t generally move that much so you shouldn’t have to worry about missing out on much return while you put money back in the account. These emergency circumstances also make a good case for investing in peer loans. Peer loans pay interest and principal each month so it’s a bigger cash flow than other bond investments. That means you can tap that uninvested cash in your account for quick emergency expenses when they arise and you won’t have to pay trading fees or taxes on selling your investments.
Goal Planning and Asset Allocation for Your Investing Needs
This last section of the lesson is one of the most important investing concepts and is really going to tie in the previous two concepts. It’s so important that I’ve dedicated an entire lesson to it in this course but I wanted to highlight it here since we’re talking about the different asset classes.
One of the biggest mistakes in investing and really throughout almost everything you’ll see on TV or online is that it is a one-size-fits-all journey. Tune in to your favorite investing show and you’d get the impression that all you need to do is pick a few stocks and hold on for the ride.
You might even hear that you need to hold your stocks forever to avoid those bad investing behaviors that lose money and to reach your goals.
This is closer to the truth but still misses a very critical step investing for your goals, that your investments need to be customized to fit YOUR goals.
You might not even need stocks to meet your financial goals or you might not need much in stocks. Maybe you don’t want so much risk in your investments and you’d be better off with more in bonds or other assets.
The problem is that most investors don’t really know what their goals are or how to get there. Sure, they might have a rough dollar figure for how much they want to have saved in 20 years but they have no idea of the path that will get them there.
It’s like leaving on a roadtrip, knowing only vaguely where you want to go but with no map and no idea how to get there. You’re just going to drive aimlessly until you run out of gas.
And that’s what happens to most investors. They run out of gas, see their investments going nowhere and give up. They start taking money out of their account because, “Why not, might as well spend it now. It wasn’t going anywhere anyway.”
The most critical concept for investing is to have a clear destination and a roadmap for getting there. The only way to do this is through an Investment Policy Statement (IPS).
An IPS is a written plan that starts with calculating how much you’ll need to reach your goals. This isn’t just doing the math and guessing you need about a million dollars. This means visualizing what retirement looks like for you, putting a picture together for exactly what you want to do and how much it will cost.
The IPS also looks at your tolerance for risk. This is an extremely important section but so often avoided. The section looks not only at how changes in your investments affect you emotionally, causing you to stress out and lose sleep, but also at your financial ability to handle risk. Understanding your risk tolerance completely will make sure you are investing in the right assets for YOU and not just a template plan of investments.
With a written IPS, you will know exactly how much of your portfolio to put in stocks, bonds, real estate and other asset classes. You’ll understand how to invest your money within the asset classes, so how to invest within the sectors in stocks, and how to change your investments over time.
I’ll guide you through creating your own Investment Policy Statement in the next lesson, showing you exactly how to find how much return you need to meet your goals and how risk affects your investments. I’ll also show you how to think about five critical factors that will guide your investing policy.
It’s going to be a longer lesson but absolutely important to putting you on the right path to reach your financial goals. So grab a cup of coffee, walk around the room, whatever you need to do to wake up and get ready. Let’s do this!
Final Thoughts on Core Investing Concepts and Action Steps
This was mostly an informational lesson to get you ready for creating your Investment Policy Statement in the next lesson.
We started with the importance of spreading your investment in different asset classes. This will do several things for your wealth-building. First, it smooths out the risk in your wealth. Instead of losing 50% of your nest egg every time the stock market crashes, your portfolio value falls only a fraction of that and continues to rise steadily. That means less stress and investments you don’t have to worry about.
Investing across asset classes will also open up opportunities to take advantage of the market. When stocks do take a nose dive, you’ll be able to sell some of your safety assets in bonds to take advantage of cheap stock prices. It’s not about timing the market but about rebalancing your wealth when some assets are expensive while others are cheap. We’ll get into how to do this in another lesson in the course.
Finally, investing across asset classes lets you customize your investing experience for your needs. You’ll know exactly where you want to go and the best investments to get you there.
Remember, the four asset classes are:
- Stocks provide the potential for higher returns but involve a lot more risk. Within stocks, you’ve got nine sectors with different levels of risk and potential returns. Stocks will follow the economy higher or lower though each sector responds differently to economic trends.
- Bonds are a safer asset but generally provide lower returns. Bonds are an obligation to pay for the borrower and bond investors get paid before stockholders. Bond interest is paid twice a year and bondholders receive a lump sum when the bond matures. Bonds are issued by governments, corporations and you can now invest in loans to individuals as well.
- Real estate is somewhere between the safety of bonds and the returns on stocks. Direct purchase gives you more control and direct cash flows but requires a bigger initial investment and ongoing management. Indirect investment through REITs gives you instant diversification and stable cash flows but less control. Real estate crowdfunding may be a way to get some of the advantages in both direct and indirect investing.
- Alternative investments offer the potential for much higher returns but also much more risk and may lock up your money for much longer. Investors with less than one million dollars net worth may not be allowed to invest in some of these and they aren’t entirely necessary to meet your goals anyway.
We also talked about liquidity and how to set up your emergency fund. Resist the temptation to skip this step. You may not be earning much on those funds but they will save you from financial ruin if you need the money quickly.
Finally, we previewed the Investment Policy Statement and how it will help you tie everything together into an investing plan that is right for you. We’ll work through the IPS in the next lesson.
For now, go back through the emergency fund section and put together how much you need and how much you can save each month.
- Look to your health insurance deductibles to estimate how much you would need to pay in an emergency.
- Look back through your last year’s credit card statements and bank accounts to see exactly where your money went.
- Work through your monthly budget to include all the infrequent bills that might throw off your savings.
- Estimate how much you spend a year on auto and other repairs to plan on saving a monthly amount to cover the expenses.
- Add these amounts to at least a couple months’ worth of expenses in case of income loss to get an estimate for how much to put in an emergency fund.
- Save each month to put in your emergency fund investments. When you’ve reached your goal amount, keep saving but put that money in your regular investments and retirement accounts.
These core investing concepts are so important but so often overlooked. They aren’t as exciting as talking about a hot stock investment but are critical to how you invest. Understanding these basic investing ideas will help you put a plan together and take the guesswork out of picking your investments. When you know how to invest, you won’t have to worry about the ‘what’ of investing.