How to Decide What to Invest in and Diversify
In the last couple of weeks, we’ve discussed how market volatility can be beneficial, and why you should be making regular investments. (check out this post on volatility, and this one on timing the market.) Once you’ve determined your investing budget, you need to decide how to invest that MON-AYE! Which brings us to today’s discussion.
Last week, we discussed why it is hard to time the market. The same is true of picking a good company to invest in. Yes, sometimes you get lucky and buy a stock like Apple when the company is in its infancy, and years later you become a rich bitch. But like timing the market, picking the unicorn of companies to invest in is like playing the lottery. Pure luck.
Let’s start with some investing basics. Buying Apple’s stock is an investment. When that investment is grouped together with all of your other investments, this conglomerate of investments makes up your portfolio. Your investment portfolio includes all of your stocks, bonds, real estate, crypto currencies, etc. The goal is to create a portfolio with a level of risk that you are comfortable with, and receive the highest possible return on that portfolio. (To get a more comprehensive understanding of the risk/reward trade off, see this post.)
Playing the lottery has a high level of risk because the odds of you winning are very low. If you manage to beat the odds and win, you will receive a high return. However most people don’t become winners and lose money playing the lottery. The same concept can be applied to picking a unicorn company (this is a real term by the way). Venture capitalists use this strategy. They invest millions of dollars in lots of risky startups, and sometimes they get lucky and find a unicorn company and make shit loads of money. But most of the time, they’re losing money on their risky investment choices. This is like buying a bunch of horses with a disease that turns 1% of them into unicorns the other 99% die. The odds aren’t great and you’ll probably end up with a bunch of dead horses. So if you’re a venture capitalist, you can stop reading now. For the rest of you, let’s keep going.
To decrease your level of risk you want your portfolio to be well diversified. This means that your portfolio contains various investment types, in various market sectors, and in diverse geographical regions. This type of investing is more like buying a herd of cattle than a unicorn. You have lots of cows (investments), and if one gets sick, you still have the rest of your healthy herd (portfolio) to keep making you money. It isn’t as shiny or fun as investing in a unicorn, but it is a much less risky investing strategy. So how do you choose well-diversified investments for your portfolio? You have several options.
My favorite diversification option is to invest in a target date fund. A target date fund is a diversified fund that decreases your risk level as you get closer to your target date. This is popular with retirement accounts like 401Ks or IRAs where the target date is your retirement date. The premise behind this is that a higher percentage of your investments should be in riskier assets when you are younger because if you experiences losses, you have plenty of time to recover from those losses before retirement. The closer you get to retirement, the more impactful losses will be because you will have less time to recover from them. Therefore, you should reduce the risk level of your portfolio and lower the percentage of your investments in riskier assets as you age. Target date funds do this for you. Each year they will reallocate your investments based on your target date and automatically reduce your risk over time. This saves a lot of time on your end, and an added bonus is that many of these funds have low or zero trading fees, and minimal maintenance fees.
If you don’t want to use a target date fund, you can research your own strategy for diversifying, and then pick investments that fit it. See the chart below for an example of different asset allocations in a portfolio.
If you decide to build your own portfolio, two great options for diversifying are index funds and Exchange Traded Funds (ETFs). Indexes track a group of companies. You are probably familiar with these even though you may not know it. The S&P 500 index compiles 500 companies and tracks all of them together as 1 investment. The Nasdaq and Dow Jones do something similar. There are also lots of foreign indexes to choose from.
Index funds can be quite expensive, so ETFs allow you to buy a portion of 1 share of the index fund. This way, you can still reap the diversification benefits of the index, but at a fraction of the price. Both of these investments track the overall market in a region as opposed to a singular company. This can be beneficial when certain sectors of the market burst or perform poorly. A great example of this was when the dot-com bubble burst in the 1990s. If you were heavily invested in tech stocks and were therefore not well diversified, you would have lost a lot of money compared to someone who had investments in many market sectors. Again, when one cow is sick, you still have the rest of the herd.
The downside to structuring your own portfolio is that it is much more time consuming because you need to reallocate your investments at regular intervals (ie: annually) to compensate for any percentage changes that have occurred. For example, if you had a really great year and made a lot of money on your US stocks, you may now have too high of a percentage of your portfolio invested in US stocks and need to reallocate the extra funds to the rest of your portfolio. On top of that, you will also need to review your overall investment and diversification strategy as time goes on to make sure you are reducing your risk over time. Unless you are extremely interested in investing, I don’t suggest this approach.
The last option is to pay someone else to manage your portfolio for you. Unless you have hundreds of thousands of dollars or more to invest, I think this is a terrible option. Your portfolio manager will charge you tons on fees that will eat into any gains you make and lower your overall return. They also usually don’t perform better than the market, so why pay them to do what you can for free!
So there you have it! Don’t invest in the shiny unicorn. Invest in the herd of boring ass cattle! Slowly but surely and with minimal stress, they will make you a rich bitch!