Investing Primer: Risk, Asset Allocation, Diversification

This is my third post in my investment series.  The first post is about saving and the second post is about stocks and bonds.

Today I will talk about risk, asset allocation, and diversification.

Risk

As I discussed in my previous post on stocks versus bonds, you need to take some stock market risk in order to get the larger returns necessary to provide you with a comfortable retirement.

With investing, the more risky an investment is, the more rewarding it may be.  When investing for retirement or for other reasons, we want preserve the original amount we invest (principal) and we also want to see some nice returns (gains) as well. 

 There is randomness and uncertainty in the stock market.  The only guarantee you have in investing in the stock market is that past performance does not guarantee future results.  Anytime you put money into the stock market, you risk losing your principal.  This means that your money may not be available for you when you most need it.  In the short run, drops in the stock market can make for great buying opportunities to pick up some more shares, especially if you are young and don’t need to access the money for many years.

The older we get, the less risk we should take on.  Instead we should focus on preserving our money.  This is why most financial experts recommend owning less stocks and more bonds as we get older.  

Asset Allocation

Asset Allocation is basically how you divide up your money into stocks, bonds, and cash (the primary asset classes).  Your asset allocation is the ratio of stocks to bonds in your investment portfolio.  You can manage your level of risk by choosing the right asset allocation.  Many aggressive investors learned how risky investing in the stock market could be in 2008 when stocks fell 50%.  Those who ended up bailing out near the bottom didn’t stick to their aggressive asset allocation and actually abandoned their investment plan at the worst time possible.

Before you decide on your asset allocation, you need to determine your level of risk.  The more risk you can handle, the less bonds you need.  The more stocks you own, the more potential you have for big returns.  However, the more stocks you own, the higher the risk of loss is.  In the stock market crash of 1929, there was a 90% drop.  It’s unlikely this will happen today, but it could.

Having different investment goals such as purchasing a new home, paying for college for your children, and retirement all require different asset allocations.

The amount of risk that you choose to bear depends on many factors such as your age, your job security, your personal savings, and your emotions.  If the stock market is crashing, do you see this as an opportunity to buy more shares on sale? Or do you fee like you have to “get out” before you lose any more money?

Vanguard has a risk assessment questionnaire for you to use here to help you determine your asset allocation.

Diversification

Diversifying means placing some money in different kinds of investments to spread the risk.  One simple way to get diversified with stocks is to own an index fund that tries to approximate the entire stock market.  This guarantees that you will receive the average returns of all investors.

 Investing doesn’t need to be as complicated as financial advisors would like you to think.  The more complicated your investments become, the higher probability you may have to lose more money.  You don’t need to be a stock picking professional or have very expensive software programs.  Most people don't need a financial advisor.  Many self proclaimed "financial advisors" are essentially glorified salesmen.  The more fees you pay in having someone else manage your money, the less of your money you get to keep.    

For most investors in most situations, index fund investing is the best way to go.  Investing in Index funds appropriately can give you the best after-tax return with the least risk on your investment dollars.  Investing in index funds makes investing simple and gives the average person (with no financial background) the opportunity to become more successful than most individual stock pickers.  

Warren Buffett has recently said "few investors have the time and the temperament to study companies and industries thoroughly enough to become expert stock pickers.  Most would be better off buying low-cost index funds.  Such funds let you buy into American business in a diversified way, over a long period of time."

My entire portfolio is made up of different index funds.  I will share my detailed investment portfolio with you in a future post.  My current asset allocation is 90% stocks and 10% bonds.  Within my stock holdings I have 70% invested in US domestic stock market and 30% invested in International stocks.  

With only a handful of index funds, my portfolio includes over 6,100 US stocks, over 6,400 International stocks, and over 5,800 Bonds.  This allows me to have maximum diversification.  This is what I’m comfortable with; your risk tolerance and asset allocation may be completely different from mine.

So that’s it for today on risk, asset allocation, and diversification!  I will talk about investing in mutual funds in my next post.