The next step would be to begin a plan of diversification. With bonds we can go with long or short, bank grade or junk, government or corporate, taxable or tax free. In stocks we have the option of large, mid, or small; value or growth; domestic or foreign; in Real Estate Investment Trusts (REITS) we can have commercial, apartments, industrial, or malls. Notice that our corporate models do not help too much as they lack the detail we are seeking.
Should we build with mutual funds, individual stocks, or exchange traded funds? The answers depend on what is available to you either through your retirement plan, IRA or regular account. Be aware of fee expense. Larger amounts of money can trade cost effectively in stock and bond and ETF purchases. Mutual funds can come with no up front charges but have ongoing fees. See investment basics.
How should you proceed? First, have your goals clearly defined; including your time frame, priorities, and "risk tolerance". But, what is risk tolerance?
The investment industry has created artificial measures such as 'conservative', 'moderate', 'aggressive', or 'speculative'. We don't know exactly what these terms mean to us as individuals; let alone what connotation they carry for others. The ratio of stocks and bonds is the most common measure of being a conservative or aggressive investor. However, that ratio should be decided by you not only after becoming well informed, but as measured by how well you sleep at night. If it doesn’t seem right, then either you don't fully understand your investments, or they are not right for you and should be changed. Think of investments as a work in progress. Modifying your portfolio is no big deal as you learn more and the world changes. Give it your best ideas to start and then, fix things as you go. But do get started. Too much over analyzing can lead to falling victim to inaction
The following charts and graphs are not meant to confuse, but rather to illustrate all of the possibilities available to you. At the end of this section we will suggest a few options that we like to use as a guide to establishing an investment plan. You may not get all of the pieces in place immediately, it should take awhile.
First let's take a look at why we really can't figure out which asset class is going to be worst or best for any given year beginning in the United States.
The Importance of Diversification
From year to year, there's no telling which asset classes will be the best performers - a strong argument for portfolio diversification. The chart below ranks the best to worst performing asset classes from top to bottom for the years 1996 to 2005.
Click For Larger Image (pdf)
Notice that the above graph does divide between both small and large cap growth and value but it misses mid caps and foreign stocks altogether. That's okay, because it starts our developing the allocation picture and brings into clear view that an asset class can go from best to worst or vice-versa in a hurry. Note small cap in 2002 and 2003.
Now, it is time to begin the process of selecting the pieces of our allocation pie. First, we must determine the size of that piece relative to the other parts and lastly we must decide how we are going to build the pie with the tools at hand including mutual funds, EFTs, or individual investments.
Large cap growth, along with large cap value has traditionally made up a significant part of the investment process. Their total return over a longer time has not been as good as those of the smaller companies. On the other hand, large cap has provided a greater sense of well being because you recognize the names and know their products. They also tend to be less volatile than their smaller cousins. This group can be bought as individual holdings, exchange traded, or mutuals because they are broadly tracked and widely followed. And, it is nice to be able to say you own Pfizer, General Electric, and so on. But for cost effective ownership and diversity, the exchange traded fund with their low operating cost for a buy and hold position would provide you with a basket of these bigger companies. This reduces the risk that comes with owning only a few individual companies. A traditional mutual fund that is well run, with low operating costs can also be a good tool that allows you to switch your holdings around without additional costs. A blend of large caps through mutual funds allows for a diversified position in both growth and value and can have a low entry cost and on going cost.
Mid caps may be treated pretty much the same way as large caps. But here, that division between growth and value is more clear-cut than in large cap. Your approach can be similar to large cap but tracking individual holdings is more challenging. Owning individual holdings especially in REITs and high dividend payers may make individual stocks worthy of consideration. But this approach for a smaller portfolio needs to be carefully considered.
Small cap and Russell 2000 are important because over time they have been the best performers by far. They are available as growth or value but are very volatile and should be well diversified in either an ETF or mutual fund. As with all charts and graphs, individual investment expense is not reflected.
REITs are generally mid or small cap stock holdings so they can distort our allocation plan. That is we might be over weight in mid and small caps by including them as mid and small cap. We think that they act independently enough to be a separate sub-division. The dividend return for REIT's is significant and represents an important part of your total stock return. One individual REIT purchase buys you a diversified portfolio of real estate with management fees already built in. This makes sense because of property taxes, and all the other expenses that come with real property management.
When you buy REITs through EFTs and or mutual funds you add another level of management because there is a team of people buying, selling and watching a number of different individual REITs for you. Here, you would be looking for geographical diversification as well as different types of real estate in your holdings. In other words, 7-15% REITs and 10-15% small or mid caps counted separately are not, in our view over weighting and can make a positive contribution to your own asset allocation plan.
Asset Allocation
Go To Page
1
|
3
