As mentioned in the previous post, there are multiple ways to diversify a portfolio. Some considerations are investing horizon (how long for investment to grow), geography (U.S. vs. international stocks), market capitalization (large, mid, or small companies), market cycle, industry sector, bonds, short term or cash equivalents, and alternative investments (real estate and commodities).
“Remaining disciplined, unemotional, and mitigating risk are some of the keys to investment success. Maintaining an unbiased and unemotional stock selection process and consistent portfolio management practices can help with achieving success.” Jeffrey A. Hirsch
Investing Time Horizon
One key to successful investing is balancing your risk tolerance with your investing horizon. Investing too conservatively when you start may mean that the investments may not grow enough to meet your goal(s) or keep up with inflation. If invested too aggressively as your horizon approaches, there is the risk of a market downturn that would reduce the value of your investments leaving you with little time to recoup the losses before you need to withdraw funds. One older simple allocation rule for retirement funds is to subtract your age from 100 to calculate the percentage that should be invested in stocks or equities. As life expectancies have increased, the advice is now to use 110 or 120 to subtract from.
I am including some portfolio graphics from Fidelity showing some different allocations and how they are rated for “Aggressiveness”
General Investing Investing Ratios from Fidelity
Some additional examples from Vanguard are included in my Target Date Fund post.
Geography and Globalization
Globalization should be considered as a factor in a portfolio. Some large U.S. companies are considered multinational (generating 25% of revenue outside the U.S). Markets outside the United States will offer more representation in other parts and industries of the global economy than that offered by the multinationals. Having investments spread across domestic and international assets will allow the portfolio to benefit from the regions that are performing well and offset areas that are under-performing. Options for investing include global/foreign, specific regions (Ex. Asia/Pacific, Europe, Nordic, Latin America…), and individual countries (Ex. Canada,Australia, India, Japan…). Keep in mind that currency fluctuations can be a source of additional volatility.
Weighting (Market Capitalization)
There is no ideal or “right” portfolio allocation, since everyone’s situation and risk tolerance is different. Portfolio optimization has multiple formulas that can be used. Most are based on calculating the risk and return across different assets to construct a portfolio that will meet the investor’s goals and risk tolerance. Mutual funds and ETFs provide more diversification than stocks, but you may want to consider other funds or investments to cover different sectors of the market. For example, U.S. equities can be subdivided into Large, Mid, and Small Capitalization. and each assigned a different percentage in the portfolio. Each U.S. market capitalization can also be subdivided into Growth, Blend, or Value categories.
An optimization weight can be calculated for each asset class and or subcategory. The weights are based on risk and return tolerance. To minimize risk in a conservative portfolio, a higher weight would be assigned to low-risk investments such as money markets, CDs, and bonds. Many brokerage sites have tools to assist with calculating your investment risk and investment choice (especially mutual funds and EFTs). A financial advisor can also assist in recommending investments. One thing to watch out for if using mutual funds and ETFs is to be aware of overlapping investment holdings and overall investment strategy so you aren’t doubling up on your investments.
An example of a sample weighting for a growth portfolio with a 15-20 year horizon is:
- 25% Large-Cap Stocks
- 15% Mid-Cap Stocks
- <5% Small-Cap Stocks
- 10% International Stocks
- <5% Emerging Markets Stocks
- 20% Int. Bonds/CDs/Income/Target
- 20% Short-Term Bonds/CDs/MM
Investing for Dividends/Growth
Dividends are the portion of a companies retained earnings that is paid to shareholders. They can be taken as cash or reinvested in additional shares of stock. Depending on market conditions and profitability, a company’s dividends may be paid out on a regular basis – such as quarterly or annually. Reinvesting the dividends combined with capital appreciation as the company grows in value can potentially provide total returns to match that of the broader market. As economic environments change – not every company will be able to maintain dividend payouts. There is an elite group of stocks referred to as “Dividend Kings” that have increased their dividends every year for the last 50 years. I have not provided a link because the list is updated every year. A diversified portfolio of dividend producing socks is a potential way to provide a reliable stream of income.
Market or Business Cycle
Every business cycle is different, but historical patterns can give an indication of market sectors that may perform better based on economic conditions. No investment has performed exactly the same during every cycle due to technology, regulatory and other economic changes and factors. For this reason a portfolio’s investments should not be solely based on the market cycle. Sector funds provide a tool for investors seeking opportunities during the different phases of the economic cycle. There are four phases to a market cycle.
- Early-cycle phase: Occurs as a recovery from recession or market downturn. Monetary policy eases credit and sales start to increase. Real Estate, Consumer Discretionary, and Industrial sectors tend to perform best during this phase.
- Mid-cycle phase: Continued economic growth and monetary policy becomes neutral. Inventory and sales reach relative equilibrium. Information Technology and Communication sectors tend to perform best during this phase.
- Late-cycle phase: Inflationary period where economic growth stalls and monetary policy tightens. Energy, Utilities, Consumer Staples and Real Estate sectors tend to perform best during this phase.
- Recession phase: Low economic activity and corporate profits decline. Tight credit and monetary policy starts to ease. Consumer staples, Health care and Utility sectors tend to perform best during this phase.
Investing Defensively
“When you see a big drop in your savings on your account statement, it’s likely that you’re going to have a visceral reaction. But that’s when you need to buckle down and try to stay focused on long-term goals rather than short-term volatility.” Scott McAdam, institutional portfolio manager with Strategic Advisers, LLC
Investing defensively allows you to create a portfolio that helps weather sudden changes in the market by selecting investments that tend to be more conservative in their returns or tend to have less volatility. You may sacrifice some higher returns, but in exchange, you could have shallower dips in your portfolio when the market has a downturn. Investors who are risk-adverse and those who are near or in retirement due to the shorter investing horizon may consider this approach attractive. Some investments to consider for a defensive portfolio are:
- Conservative US and International companies (or funds that invest in them) that have strong balance sheets with steady earnings growth and a historical record of lower volatility. The list of “Dividend Kings” would be a potential starting point to research for US companies.
- US Treasury Bonds and CDs (Certificate of Deposit). Treasury bonds have a history of rising in value when stocks fall sharply. Treasury bonds are sold for 20 and 30 year terms and pay a fixed rate of interest until they mature. Treasury Bonds can be sold before they mature or held until maturity. There are 2 types of CDs, Bank and Brokered and they are offered in terms from 3 months up to 20 years. Bank CDs are purchased directly from the financial institution, pay compounded interest, and have a penalty for cashing out early. Brokered CDs are sold through a brokerage, pay simple interest (paid monthly, quarterly, semiannually or annually), and can be sold on the secondary market for a fee. Bank CDs are FDIC insured and brokered CDs may or may not be FDIC insured. Investing a portion of your portfolio in bonds and CDs will protect the underlying investment and provide the coupon or interest rate of return during the term of the investment.
- Treasury Inflation Protected Securities (TIPS). TIPS are sold for 5, 10, and 30 year periods and are designed to protect against inflation. Unlike other Treasury securities the principal (called par value or face value) goes up with inflation and down with deflation. A fixed rate of interest is paid ever 6 months on the adjusted principle so the amount of interest varies. When a TIPS matures, you will get either the increased (inflation-adjusted) price or the original principal, whichever is greater. You never get less than the original principal. TIPS can be sold before they mature or held until maturity.
- Alternative Investments. Non-traditional asset classes tend to be less correlated with stock and bond investments and are generally not as easy to buy or sell as traditional investments. Hedge Funds may hold stocks and bonds but also may hold derivatives. Derivatives are financial contracts that allow hedge funds to invest in assets without owning them directly and can include options, futures, and swaps. Real Assets include private real estate, fine art, collectables, commodities, and investments in infrastructure. Commodity- focused funds such as oil, gas, mining, and natural resources can provide a potential hedge against inflation. Real estate funds including real estate investment trusts (REITs) can also help diversify your portfolio against inflation.
Asset allocation funds
For investors that do not have the time or confidence to build and monitor a diversified portfolio and don’t want to hire a planner or manager, Asset Allocation funds are another option. The largest category of allocation funds is Target Date Funds which I discussed in an earlier post. There are several other types of allocation funds. Target Risk funds are designed to set an allocation and risk level such as 85% Stocks and 15% Bonds/Money market or 20% Stocks and 80% Bonds/Money Market. Balanced Allocation funds are designed to provide modest growth with below average risk. Income and Real Return funds are designed to generate income from bonds, dividend paying securities, and investing in a diversified mix of fixed income and equity investments selected for their historical performance.
A Reminder: While diversification may reduce overall risk, it does not ensure a profit or guarantee against a loss.
