Once you get your fundamentals under control and have begun true lifestyle design, your financial fitness is off to a solid start. The next most pressing task is investing. This is due to a very simple financial concept: the time value of money. The basic idea is that money now is worth more than the identical sum in the future due to its potential earning ability and the power of compounding. So getting your investments in order and investing in the right ways as soon as possible are incredibly beneficial.
The first part of investment management concerns the initial portfolio construction, which we will discuss below. More important, however, is the ongoing maintenance, rebalancing and discipline in sticking to a sound investment philosophy. We will save those components for our next discussion.
Investments Component #1: What Is Risk Profiling?
It’s not uncommon to have no idea where to begin when it comes to investing. But like many things we discuss, it all starts with you and your goals. For investing, that’s where risk profiling comes in. Before you start selecting investments and allocations for your portfolio, you have to know what your goals are. Those play into how much risk you may need to take. Additionally, you need to know how much risk you can take and how much risk you are comfortable taking.
Of those three distinctions, the most limiting factor is how much risk you can take, followed by your comfort level. This is a rare instance where your goals may come last in the decision process. That simply means your goals may need to be adjusted so you can take on a reasonable amount of risk without causing yourself undue amounts of stress.
How much risk you can take largely depends on your current financial situation. Do you have enough cash flow to cover your current expenses? Do you have an adequate emergency fund to cover a couple months’ worth of expenses should something bad happen? How much time do you have before you need to start drawing off of your investments? How long will those funds need to last you? These are all discussions an advisor can walk you through to help determine how much risk you can take.
Your comfort level with risk is largely dependent on you. A popular way to determine your risk tolerance is to walk through some examples of market performance. For example, imagine a three month period where your total portfolio lost 25% of its value. Would you sell everything out of fear? Would you do nothing and ride it out? Or would you see it as a buying opportunity and invest more? These are varying responses that reveal an underlying level of risk tolerance.
Another useful exercise is to view hypothetical returns based on historical data to see what kind of allocation you would be comfortable with. For example, a portfolio of roughly 60% stocks and 40% bonds would have compounded an annual return of 9.4% from 1970-2016. However, the worst year in that time period would have seen your portfolio decline 20.9%. Are you comfortable weathering the short-term volatility for the long-term benefit?
After you’ve seriously considered your risk capacity and tolerance, you can decide on your need for risk. Your lifestyle projections come into play at this point. Discussions with an advisor can help you determine the maximum level of risk you should be taking. However, if your goals don’t require the level of growth from that maximum risk, it could be prudent to take less risk, while still remaining on track for your lifestyle projections.
On the other hand, if your goals call for even more risk, you need to take a serious look at your spending and lifestyle goals. You should never over-extend yourself from a risk standpoint. After all areas of your risk profile are combined, you can begin constructing a portfolio that fits the mold.
Investments Component #2: What Is Asset Allocation?
The bulk of portfolio construction centers around asset allocation. This is where you or an advisor determine how much of your portfolio should be investing in different asset classes. On a broad level, this is a split between stocks and bonds. On a deeper level, the distinction between asset classes can include a number of factors including, but not limited to:
- Region (U.S., International, Emerging Markets)
- Size (Large Cap, Mid Cap, Small Cap)
- Bond Duration (Long-Term, Intermediate, Short-Term)
- Bond Credit Quality (AAA, AA, A, BBB, etc.)
These are just a number of ways to split an asset allocation into deeper components. The key is developing an allocation with a risk profile that matches your own. Additionally, the mix should provide enough potential growth to support your goals. This balancing act is the art and science of investment management. It is also an area where an advisor can significantly help. This is especially true when it comes to sticking with a determined allocation through good and bad times. An additional, important benefit to proper asset allocation ties into our third component: asset diversification.
Investments Component #3: What Is Asset Diversification?
We’ve all heard the old adage, “Don’t put all your eggs in one basket.” That is essentially what diversification is. For investment management it is two-fold.
First, it ties into asset allocation. Different asset classes have different return and risk characteristics. They are all affected differently by various economic, business, and market environments. Being diversified across asset classes helps lower your portfolio’s overall risk, without much impact on potential returns. If you’re invested in U.S. and International stocks, then your portfolio is somewhat protected in a case where one or the other has a downturn.
The goal is having a mix of asset classes with low correlations. Correlation between two classes measures how similarly they move together. As an example, large and mid-sized U.S. stocks typically have a high correlation, while large U.S. stocks and bonds tend to have a lower correlation. This is why bonds are used to reduce the risk in a portfolio, despite their historically lower return potential.
The second piece of asset diversification comes within each asset class. In portfolio construction, after you’ve determined your overall asset allocation, you need to fill each of those buckets with actual investments (stocks, bonds, mutual funds, exchange-traded funds (ETFs), etc.). In doing so, you should utilize mutual funds or ETFs that give you exposure to hundreds or thousands of different individual positions within each asset class.
The alternative is investing heavily in individual positions. However, that leads to poor diversification and a large dependency on single companies and organizations. If history tells us anything, even companies thought to be invincible can collapse. Fortunately, diversifying your investments is an easy way to insure your portfolio against such risk.
How does it all fit together?
These are all the important steps to crafting a portfolio that fits you and ultimately serves your goals and priorities. It’s important keep that in mind. Investments, like money in general, are a means to an end. Many people get caught up in trying to maximize returns, investing in hot stock tips, and having better performance than their friend or neighbor. That’s a dangerous game to play.
Your initial focus should be on developing an accurate risk profile for yourself. Once you know how much risk you can take, are willing to take, and need to take, you can focus on building the portfolio. Be sure to have an appropriate mix of asset classes and be properly diversified among and within them.
These steps coming together should help you build a portfolio that’s right for you. However, it can be tedious and hard to know whether or not you constructed it appropriately. This is an area where talking to an advisor and gaining their assistance can benefit you greatly in the long-term. They can also help maintain your portfolio moving forward and help you stick to a disciplined investment approach. These are components we will discuss in part 2 of Investments. As always, if you have any questions or want to reach out, please contact us.