Setting up an investment plan that will last for years is really a matter of a few simple filters. For instance, the Brinson study shows that your investment portfolio should be 93% stocks, bonds and cash.
What percentages of each will be the big, overarching investment plan decision you’re going to make. It’s going to tell a financial advisor what reasonably to expect from a portfolio over time, and what you can live on in retirement.
Some studies even show that asset allocation, what investments you own and in what amounts, in fact determines 100% of your return. Meanwhile, stock picking and market timing are net negatives, so don’t bother.
As a rule, cash really has no role in a portfolio except for emergency needs or psychologically for comfort. If anything goes wrong, having some cash means you can pay for it. You don’t have to sell any of your investments to raise money.
Own bonds for anything that’s a fixed amount that you need to pay sooner; that’s your “five years or less” money. Assuming you have your liabilities covered and sufficient emergency money, the rest should be invested in stocks.
Even so, fixed-income investments, typically bonds, are really just a volatility dampener. Keeping cash also can be a volatility dampener.
That’s why people need a financial advisor, so that the market’s ups and downs don’t bother them psychologically, and to make sure that you have planned for your spending needs.
Given all that, how do you invest in equities? Consider these three categories: U.S., developed international and emerging markets stocks.
That’s the next level of diversification. Now, within those areas, you’re going to have three choices for stock investing: value or growth, large or small, active or passive.
In the end, how you diversify doesn’t matter as much as that you are diversified. People get crazy with pie charts, but we already know that stocks will beat bonds and cash.
U.S.-domiciled companies probably make 50% or 60% of their money overseas, so you own a lot of effectively international equities by default. Accordingly, it might not be worthwhile to overweight international holdings.
We have a good capitalist system in this country and rule of law, so there’s no reason to own a lot of foreign stocks. Plus, if you own the S&P 500, you already have a lot of diversification anyway.
Left to their own devices, however, people often own too much large-cap dividend paying stocks and they don’t own enough small cap and not enough in international and emerging markets.
Remember, dividend-paying stocks are not risk-free. People forget that companies can go under or stop paying dividends. Dividends get cut, it happens.
Passive investing is likely the best approach, and the benefit that doesn’t get talked about it is what it does to your behavior as an investor.
One of the great benefits of owning broad index funds is that in effect you are saying, “Okay, I’m not going to time the market. I’m not going to pick investments. I’m not trying too hard.”
That’s a behavioral help for the investor; there’s much less buying high and selling low. But it’s not risk-free.
In 2008, for instance, some people still panicked out of index funds. It’s investor behavior that keeps people from retiring, not that a fund performed a little less than the stock market index.
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