Buying individual stocks is a suckers game (the clowns on CNBC have it wrong). Investing, across a broad range of assets, is not.
Heaps of financial research has shown that asset allocation is the single biggest factor driving investment portfolio performance. “Managed money” in mutual funds or handled by investment advisors almost always results in a lower return over the long run.
The only case I can come up with in favor in picking stocks is when you are wealthy and/or informed enough to have a “seat at the table”, as venture capitalists or large hedge fund investors do. If you don’t have the opportunity and capacity to meaningfully and directly support the company’s strategic direction (like Warren Buffet!) don’t invest in it directly. Otherwise, it’s just plain old gambling.
Cash is safe but will eventually erode in value due to inflation and low interest rates on CDs And money market accounts make those cash-like investments impractical over the long term (unless rates change).
The question then becomes, how does one create a balanced portfolio with the proper asset allocation? Where do you put your money when the bank hardly pays any interest.
The ingredients for a portfolio are incredibly simple:
1. Cash – defined by how much you need to have on hand to cover living expenses day to day.
2. Bond index fund – one that has a mix of short and long term bonds.
3. Stock index fund – one that is globally weighted according to a standard index.
For cash, be super conservative. Keep a large stash of emergency funds. Some financial planners advise an 8 month emergency stash assuming zero income and essential living expenses. Make it a year if your financial situation allows.
For bonds, don’t pick specific bonds. They can be as risky or riskier than stocks! Also watch out for long term bonds that can swing wildly in price. Stick to a broad index of bonds that have a short to mid term duration.
For the stock index investments, the S&P 500 index isn’t enough. You need to have exposure to mid and small cap stocks in the US and also the global stocks not listed on the US exchanges. Doing this will require at least two index fund purchases, one that tracks the US market in total and another that tracks the World market in aggregate (not including the US).
The key thing for bond and stock investments is to buy the absolutely lowest cost index funds that represent a broad based index (not actively managed funds). Over time, even fractions of a percentage of expenses will cost thousands (or tens of our ands depending on your portfolio value).
Most major investment houses (I use Fidelity, but Vanguard is another good one) have low cost index funds covering the required asset classes. To give you an idea of how low the expense ratios should be, I invest in a Fidelity Spartan Total Market Fund that tracks the broad US market (small to mid and large cap) and has an expense ratio of only .10%!
For international index funds you might pay an expense ratio closer to .25% or so. Just look for the lowest cost and make sure it tracks the proper broad based index for the asset class. If you aren’t sure, ask someone who knows or research online 🙂 . Don’t get duped into choosing an “international” index fund that ends up being European market specific or also invests in the US. Do some homework.
Too many people get tricked (or are just too lazy to do the homework!) into picking funds with fees north of .5 or even 1 or 2%! That’s just throwing money away.
Before buying any of these assets, however, you will ultimately need to decide on your asset allocation. There are numerous online tools and calculators to help you figure this out. It depends on as, near vs long term cash needs and risk tolerance.
One rule of thumb I’ve heard of is to subtract your age from 100 and that becomes your stock allocation. The rest is bonds (this assumes you have a separate cash savings not included in the allocation). This is a crude method….use the online tools to pick an asset mix.
Personally, I have a much more conservative asset allocation, since my career is in a high risk industry (high tech) along with a portion of my compensation (company stock) and I factor this into my overall portfolio allocation decision.
Regardless of what your allocation is, the most important thing to do is have some sort of allocation, period. Don’t put all your eggs in one basket. I know too many people that have invested their entire 401k in Microsoft stock (where I work) over many years, and don’t think twice about it. Whenever I hear this I cringe!
That is gambling. Investing is different. Investing means having a plan…a strategy. It means not trying to time the market or pick stocks, but in sticking with the plan over the long term.
This also applies to investing only in stocks, even in stock index funds. That isn’t a balanced portfolio (unless you have done so with 100% intentionality!). In the past few years, since the financial meltdown in the US, bonds have actually outperformed stocks. They are an important asset class and a great way to minimize volatility with relatively opportunity cost in performance gains.
When in doubt, pick a more conservative asset allocation (more bonds and cash). You can always change your mind later.
Once you have set your allocation, rebalance once a year as the asset classes shift in value to get back to your target allocation.