CHAPTER
8

Balancing Risk by Diversifying

In This Chapter

• How to allocate your money
• Different kinds of investments to balance risk with reward
• Characteristics and risks of investment categories
• Regularly reviewing your investments
• Buying and selling

What actually determines how well your investments do? Your brilliant selections? Sorry, no. According to researchers, more than 90 percent of your return is determined by your asset allocation policy. Asset allocation means how you choose to distribute your investments among various investment types in order to balance risk and reward. In this chapter, we’ll look at how you might allocate your investments to achieve the highest return you can while still being able to sleep nights.

Stocks: Risk Versus Reward

Stock investments over a long period have always returned more than bonds. During the twentieth century, stocks averaged an annualized return of 10.4 percent. That doesn’t mean they made that much every year: some years had extraordinary gains and some years had losses. But over time they’ve beaten inflation soundly. Inflation over this time period has averaged roughly 3 percent (again, with wide variations by year).

How much variation you can take, for how long, is key to your tolerance for investing in the stock arena. Let’s use the S&P 500 as a proxy for “the market.” Could you tolerate a loss of .63 percent for a decade (1930s) for a possible gain of 19.28 percent (1950s)? Maybe that sounds pretty easy, but what about a loss in 7 months of 54 percent (September 2008 to March 2009), then a gain of 200 percent (March 2009 to August 2015)? If you have long time horizons, you might be able to sit out such downturns or regard them as stocks-on-sale in bad times, but what if you planned to begin your retirement in September 2008?

For most of us, the most panicky period in recent memory was indeed 2008–2009. During that period, you would even have lost money in bonds—they fell about 8.7 percent. Not great, but a lot easier to survive than a 54 percent drop.

Let’s say you had $20,000 invested in the market. Here’s what would have happened to your money (theoretically), in that period (September 16, 2008 to March 6, 2009).

Bonds are starting to look a little better, right? In fact, cash would have been even better—you wouldn’t have lost anything. Nevertheless, it’s easy to see from the table that bonds had a protective effect on a portfolio when the stock market was tanking, and if you’d had a mix of stocks and bonds, even in the worst of times, you would have lost less than if you owned an entire portfolio of stocks. Before you rush out and buy only bond investments, however, take a look at this chart for the next 6 months after the crash (March 6, 2009 to September 16, 2009) and how your $20,000 might have fared.

Now, you’re rushing for the stock market, right? In an up market, you can see the balancing effect of bonds, but also that they are a drag on returns.

While the market in stocks can swing wildly, in the period 1928-2015, the market has been in negative territory only 23 years. So, not only are you likely to make money over the long haul because of higher returns of stocks over bonds, but the majority of the time, the stock market goes up.

The Pros and Cons of Bonds

Bond investments carry another risk—they barely exceed inflation. Here, bond mutual funds and individual bonds can differ. With an individual bond you’re locked into the rate you purchased. If you bought at a high interest rate, great, but if you bought at a low interest rate, the return may not even keep up with inflation.

Let’s step into my time machine once again. Back during President Carter’s term, inflation averaged about 10.4 percent and my first mortgage rate was about 18 percent. Bonds at the time were paying about 12 percent, but many people were happy to keep their dough in money market funds or CDs, which were paying even more. If, at the time, you were the owner of a 30-year bond paying 7 percent, you were really suffering.

In contrast, I inherited a 30-year bond from my dad that he bought in 1997 paying 7.8 percent—in today’s low-rate environment, he looks like a genius. Today, 30-year Treasuries are paying about 2.68 percent. (The one I have is lower rated.)

On average, bonds have returned 5 or 6 percent per year. If you subtract out an average inflation rate (let’s use 3 percent), you may do at least twice as well with stocks as bonds over the long term, and stocks are going to beat inflation, so your wealth and spending power will actually go up, not just keep pace (or fall behind). Nothing is guaranteed, of course.

Combining Stocks and Bonds Based on Your Age

Maybe you’re convinced you should combine stocks and bonds as an approach to investing, but how much of each? There are some rules of thumb you hear all the time:

Your age in bonds:

• At 30, 30 percent in bonds
• At 60, 60 percent in bonds

Your age in stocks:

• At 30, 70 percent in stocks
• At 60, 40 percent in stocks

As you can see, they complement each other—and in my opinion, they’re too conservative for many people.

Let’s say you need your portfolio to last for 30 years—a decent estimate of the length of a long-lived person’s retirement. Studies have indicated that a safe withdrawal rate from that portfolio is about 4 percent or a tiny bit more. But that is only if the portfolio is invested at least 50 percent in stocks, because the portfolio has to make enough over a long period of time to keep up with inflation, weather bad markets, and still allow you to begin by withdrawing 4 percent (plus increases for inflation in subsequent years). A portfolio predominantly composed of bonds isn’t going to keep pace, and you will, therefore, need a much more diverse portfolio or a smaller withdrawal rate.

In your 20s and 30s, you’re in it for the long haul. Depending on your personality and risk tolerance, and your goals, you may want to invest in stocks 100 percent. If you’re looking to build wealth over 20 or 30 years, or you’re saving for college and your future student is an infant, you have time to achieve much higher returns by accepting more risk. So what if you lose 50 percent? It might be heart-stopping the first time it happens, but over the course of 20 years (especially since you’re going to continue contributing to savings, right?), you’ll make it back.

If, on the other hand, you’re trying to build up enough money for a house down payment in 5 years, you may want a less risky asset allocation (say, 60 percent stocks and 40 percent bonds). That way, there’s a good chance the money will have enough time to grow, but also that most of it will still be there in the event of a downturn right when you hope to buy the house.

Let’s look at the other end of the age range. A 60-year-old with no other funds but investments (and a low Social Security payment) might choose a much more conservative asset allocation—perhaps 50/50 or even a 40/60 tilt toward bonds. You can’t afford to lose very much, but you still need enough of a return to (at least) keep pace with inflation and survive market downturns. But let’s say you have a high Social Security payment, a paid-off house, long-term-care insurance, and maybe even a pension (or have purchased an annuity). You can take a little more risk in the hope of having a little more spending power in the future.

Bottom line—your asset allocation is going to be highly dependent on your circumstances as well as your age, and what mix will allow you to sleep at night and not panic when the market dips profoundly. Your asset allocation should be set after some thought, self-examination, and possibly taking a risk tolerance quiz or two (see Chapter 4). You should consider your age and how long it would take for you to recover in the event of a market downturn.

Further Diversifying Your Assets

Okay, so you’ve figured out how much you’re comfortable allocating to stocks and how much to bonds. To accomplish your stock/bond allocation, you could choose two mutual funds—a total stock market fund and a total bond market fund—and put your money in them according to the percentage you established. But you could also choose mutual funds with preselected asset allocations that could accomplish your investing goals.

Balanced Funds

Balanced funds offer a predetermined percentage of assets allocated to stocks and bonds, often 60 percent stocks and 40 percent bonds. Of course, this ratio can vary based on the market and manager decisions; some markets and some managers will alter the mix to 65/35 or another ratio.

Some balanced funds are funds of funds and some are invested in individual securities based on what the fund manager believes will perform best in the given market.

Life Strategy Funds

A third option you can choose with preselected asset allocation is a life strategy fund. These funds are generally labeled “growth” (these are the most aggressive and emphasize stocks with capital gains); “moderate” (these provide a mix of stocks and bonds, with some emphasis on dividend-paying stocks); and “conservative” (these emphasize bonds and safe, dividend-paying stocks).

Target Date Funds

Finally, you can choose a target date fund, which will allocate everything for you based on when you want to retire, and put all your money in it. These can work quite well as a default choice (for example, in your 401[k]), give you quite a bit of diversification, and pick your asset allocation for you. As long as you’re comfortable with the current mix, and want your investments to become more conservative as you get older (or your child nears college entry), these are the one-stop shop they’re designed to be.

You should look at what’s in them, though, to understand what asset allocation has been selected for your age bracket. If you want to be more conservative, pick a date earlier than your retirement; if you want to be more aggressive, pick a date farther out.

The following table shows asset allocation mixes for a sample target date fund.

Note: Selections don’t all add up to exactly 100 percent because the remainder is diversified into smaller asset picks.

If you look at the mix in the target date fund, you’ll see that it’s sliced and diced into seemingly more categories than we’ve discussed so far. Look closer, however, and you’ll see that we’re still talking about stocks and bonds, but in order to diversify the portfolio’s assets, the fund has added international investments to the mix.

Choosing Individual Investment Types

With all of these premade mutual fund options available, why would you want to select your own investments? There are some good reasons.

In any market, some types of investments do better than others. If you have one fund, it’s going to average the market somewhat, since the returns of U.S., international, and bond markets will combine to produce the overall return. If you have several and need to withdraw funds, you can choose to withdraw from the ones that are up, and leave the others alone until (hopefully) they recover.

Some types of investments return higher amounts over long periods. For example, small companies tend to increase more over time than do large companies. If you’re willing to tolerate greater risk, you may want to have a larger percentage of small-caps in your portfolio; total stock market funds emphasize large-caps. (See Chapter 4 for a discussion of small-, mid-, and large-caps.)

Conversely, you can reduce the risk in a portfolio by spreading your money among different types of investments, especially if they move opposite to each other (that is, have negative or weak correlation), so that some always go up while others go down.

You may want to diversify by owning some stocks and some mutual funds. Generally it’s easier to research and choose large-cap U.S. stocks than, say, small-cap emerging market companies. You might pick some individual securities and buy mutual funds for ones you can’t easily access.

So let’s drill down further and talk about diversification. Simply put, to diversify your portfolio within asset classes is to divide those asset classes into smaller subgroups.

Diversifying Your Investments

Perhaps the most popular approach to diversifying your portfolio is to diversify based on size and location (location meaning in or outside the United States). So we might have the following:

U.S. stocks:

• Large-cap: greater than $10 billion market capitalization (Some large-caps are referred to as mega-cap if their cap is more than $100 billion.)
• Mid-cap: $2 billion to $10 billion market capitalization
• Small-cap: less than $2 billion market capitalization

All of these can be divided by whether they emphasize growth, value, or a mix.

International stocks:

• Developed markets (Western Europe, Japan, Australia, and New Zealand): These stocks can be subdivided by Europe and Pacific, by size, and so on. Total international funds will generally emphasize developed countries.
• Emerging markets (generally include Brazil, Russia, India, and China as well as other South American, Asian, and some Middle Eastern and Eastern European countries): These can be further subdivided into specific countries or regions.
• Frontier markets (countries in Africa, some Asian countries): In general these are countries with limited industry; low per capita income; the possibility of political turmoil; questionable accounting standards; and courts and systems of law that may not be well established.

Alternative investments:

These are segments of the market that perform differently from their type of stock capitalization or operate quite differently from stocks. This category includes the following:

• Natural resources (mining, precious metals companies, basic materials such as forest products and chemicals, gas and oil producers, and so on)
• Real estate investment trusts, or REITs (A REIT is a share in a partnership that owns a property or collection of properties.)
• Commodities—generally futures contracts on coffee, pork bellies, barrels of oil, and any other actual, physical thing purchased by industries (These differ from natural resources in that you’re investing in futures contracts for the substance, rather than in companies that produce the substance.)

While there may be some overlap of companies with other stock categories, in general you might consider investing in alternatives because they move very differently from the rest of the market. Sometimes they can be just about the only investment left standing in otherwise bad markets, but they are highly volatile.

Bonds:

If you didn’t have enough categories of stocks to choose from, bonds offer lots of choices by length of term, quality, type of insurer, and location.

By length of term:

• Short term matures (pays off) in 1 year or less.
• Intermediate term matures in 3 to 10 years.
• Long term usually matures in 10 to 30 years.

Usually, long-term bonds are considered the most risky, but may pay higher interest. Most total bond funds end up being intermediate term when all their holdings are taken together.

By quality:

Bond rating agencies rate the strength of the underlying company or government (see Chapter 12 for further discussion). Generally, U.S. government bonds are considered the safest.

Junk bonds pay the highest interest because they are the riskiest. They are issued by companies and governments with low credit ratings. While you may get high interest you run the risk that the issuer will default. Mutual funds average the risk by investing in multiple bond issues and decrease the return you might get by investing in just one high-paying junker.

By type of issuer:

An issuer can be the federal government, corporate, state, municipality, federal agency, backed by mortgage aggregation, and many others. In addition to varying in quality and return, some of these offer tax advantages.

By location:

All U.S., international (outside the United States, known sometimes as ex-U.S.), and global (the whole world including the United States).

A Simple Allocation

Here’s a very simple allocation (this is not an investment recommendation):

• One third U.S. stocks/total U.S. stock market mutual fund
• One third international stocks/total international market mutual fund
• One third bonds/total bond market mutual fund

Not too different from a target date or life strategy fund, in that these funds generally contain the same types of assets. No investment recommendation intended.

Don’t feel you have to choose all or nothing. Not every one of these subcategories has to be incorporated into your portfolio. In fact, research says that once you reach about 12 different types of investments, you don’t get any further advantage from diversification—you’ve become your own total market mutual fund.

Now let’s take it up a notch. Here is a more diversified portfolio:

• 10 percent large-cap U.S. stocks/mutual fund
• 10 percent mid-cap U.S. stocks/mutual fund
• 10 percent small-cap U.S. stocks/mutual fund
• 10 percent international developed stocks/mutual fund
• 10 percent international emerging markets/mutual fund
• 40 percent U.S. bonds/mutual fund
• 10 percent international bonds (or alternatives)/mutual fund

As you can see, there are many ways to stir the mix and emphasize some segments over others.

Diversifying Your Stocks

What if you’re planning to invest the majority of your money in stocks? Maybe you have a long time horizon or you welcome risk for the possibility of larger returns. Can you diversify only in stocks or stock mutual funds?

Instead of diversifying by size and whether the company is growth or value oriented, some people diversify by sectors, believing this is another way to capture the market. For example, you might incorporate portfolio sectors you believe will do well (maybe health care or technology) or ones that have done poorly but are currently low priced (perhaps communications or utilities). By distributing your investments among a variety of sectors, you hope to capture the market while emphasizing the sectors you feel have the most potential. Many mutual funds offer portfolios centered on companies in specific sectors.

If you’re really worried about how to find the perfect asset diversification, I can tell you right now that there isn’t one. It matters more that you diversify than how you diversify. As long as you pick investments that are different from each other, and stick to the broad asset allocation that is consistent with your goals and risk tolerance, you’ll have some protection and every potential of increased return. See Appendix B for books that recommend different portfolio allocations—and they won’t all agree. (We’ll consider investing in individual stocks more in Chapter 11.)

Market Timing

We’ve considered what types of investments you might buy. Is there any secret as to when is the best time to do so?

Can You Time the Market?

We all would like to think we can “time the market,” and that some chart or prediction scheme or careful trend analysis will tell us the moment to buy or sell for maximum profit. I admit that it can be fun to think about, and I’d like to believe it can be done, but I don’t think there’s any real evidence for the success of such an approach.

In fact, the evidence argues that you do better to establish your asset allocation, get into the market, and stay there. If you have good diversification, inevitably some of your investments will drop the very next day, and some will increase. That’s how we expect diversification to work.

It would be lovely if we could buy every investment at its lowest price, after which it goes straight up, but we can’t know when that is. If the investment is low, will it go lower? If it’s already higher than its history, will it drop or go even higher? Who knows?

Financial adviser and author Nick Murray notes, in his book Behavioral Investment Counseling, that for the 20 years through 2007, the average equity (stock) fund had a total return of 10.81 percent. However, the average equity fund investor had a return of only 4.48 percent.

Why? Because we’re nervous. We jump in and out of the market, fleeing to cash at often just the wrong moments. We flit from fund to fund when we read an article about some star manager who’s produced outsize returns, even though we’ll be too late to the party. We allow ourselves, as Murray says, to be ruled by panic and euphoria, and the false belief that we can time the market.

Whatever investment you buy, you probably won’t buy it at the lowest price it will sell for in any given year, and you probably won’t get dinged for the highest prices. Even if you’re unlucky in one investment (and you probably will be at some point), diversification will help minimize the pain of any losses over your entire portfolio. The longer you hold a diversified portfolio, the more your total return will match the total return of the asset class; dividends and capital gains payouts (in mutual funds) will boost your return. But only if you’re in there at all the right moments, by staying invested.

Rebalancing

Am I suggesting that you should allocate your investments, then forget about them? Not quite. You should still rebalance your investments to keep them in line with your target asset allocation.

Rebalancing is necessary if you’re going to maintain your diversification. When you rebalance your portfolio, you sell off some portion of the investments that have increased, and use that money to buy more of the assets that have dropped, returning your portfolio to its designated proportions. This is how you sell high and buy low.

When should you do this? There are two schools of thought: by date and by percent of change.

In the date method, you rebalance once a year, or once every quarter, or even once a month, preferably on the same day. Research seems to indicate that you’re better off rebalancing once a year; any more frequently and you’re not only jumping around a lot and catching brief trends, but you may be racking up higher trading costs. If you rebalance on approximately the same day every year, conditions such as when dividends are paid, when people are withdrawing to pay income taxes, or any seasonal variation offer some likelihood of being approximately consistent year over year. Whether or not this actually happens, it’s a discipline that keeps you hewing to your plan.

In the percent-of-change method, you rebalance whenever your target allocation gets out of whack by a specific percentage—for example, if your stock fund allocation is set to 60 percent and you decide to rebalance whenever it veers more than 5 percent from that allocation. Say in May it rises to 68 percent of your total portfolio, so you sell enough to return it to 60 percent, and buy enough of your other allocations, say bonds, to return them to their established percentage (in this case, 40 percent). By September, bonds have done better and they’ve become 46 percent of your portfolio. Same routine—sell enough to bring the bonds back down to 40 percent, and move the money to the investments that are down.

Using this method, you have to establish just how often you’re going to review—for most people, any more than once a month would be too arduous, and again you can incur outsize trading costs (and potential penalties for trading too frequently in some mutual funds).

Even if you decide to stick generally to rebalancing once a year, the percentage method can work quite well for investing new money or regular contributions. Direct your contributions to the investments that are under your target percentage and you’ll probably lessen the need to sell and buy existing investments when it comes time for the yearly rebalance.

In any rebalance, I’d leave as is any investment that is 5 percent or less off target. You’re never going to get it perfect—even as you place your order, the price will change. Get close and don’t sweat the small variations.

Asset allocation is the first, most important decision you will make. It will guide you in choosing what overall mix will result in a portfolio that matches your appetite for risk and goals for return. Once you’ve selected your asset mix, you’ll move on to choosing specific investments to build each asset allocation category.

The Least You Need to Know

• Decide on your general asset allocation approach between stocks and bonds depending on your risk tolerance, age, and timeline for goals.
• Dividing your investments into types of stocks and bonds can give you further diversification and more potential risk/reward.
• You may want to choose an asset diversification mix for yourself, or select a mutual fund whose investments already offer diversification.
• Rebalance your investments on a regular basis in order to maintain your asset allocation plan.
• Once you set your strategy, stick with it. Don’t worry about temporary or short-term changes in the market.