The Playbook for the Risk Taker
| In the last edition we talked about the importance of using your employer sponsored retirement plan. We hope that the message was well received and left you begging the question; “How do I properly invest my money?” |
The thing to remember when investing is that this is a very complicated ballgame. To try and pick the right fund, stock, or even area of the market at any given time is an art that is yet to be perfected. Many experts can offer statistics that suggest the timing is right for specific companies or specific areas of the financial markets, but we live in a world when nothing is guaranteed. This fact alone is the reason that the first lesson anyone should take when investing is: diversify, diversify, and then diversify. This lesson dates back to an age-old adage my Grandfather taught me when I told him I was going to be a professional hockey player, “That’s great, but don’t put all your eggs in one basket.” Needless to say, my Grandfather’s advice was dead on.
Diversification, by definition, means “the condition of being varied.” Restaurants diversify their menus because not all people like the same foods, clothes manufacturers diversify their clothing styles because not every style looks good on every person, and investors should diversify their investment portfolio because not all areas of the market will be in favor at all times. For the purpose of investing, the definition of diversification is to spread one’s risk among different securities in different areas of the economy. We do this to limit the impact that a downturn in one industry may have on our overall investment portfolio.
To better understand diversification from the investment perspective, we need to understand the different types of investments that exist today. Currently, there are three main investment options that investors have access to; stocks, bonds, and cash.
Stocks refer to shares of ownership in a company.
Bonds are loans a person issues to the government or a company with the promise of being paid back with interest. Bonds are traditionally less volatile than stocks and viewed as a more conservative investment option.
Cash, the safest of all investment options, is a liquid investment that holds its invested value.
Investors can use these three types of investments to diversify at different levels. The first level finds diversification by owning more than one stock, the second level by owning stocks in more than one asset class, and the third level by owning more than one investment option (i.e. investing some money in stocks, some money in bonds and some in cash). We will touch on each.
Stocks carry the most risk of the three investment options mentioned above. What makes owning stocks attractive is that in exchange for taking some added risk, we have the potential to see much higher investment returns. However, as we have already determined we can lessen our risk by spreading our money out among several different stocks. For instance, if ABC Company ( who sells widgets) were to report lower than expected earnings for the current quarter, their stock price would likely fall. If our portfolio only consisted of stock in ABC Company we would certainly feel the impact of ABC’s poor numbers. However, if ABC was only one of the many companies that our portfolio consisted of, the gains we may have seen from our other holdings (shares of stock) could likely offset ABC Company’s less than stellar quarter. Therefore, investing in only stock, even a diverse portfolio of stock still carries a significant amount of risk. To lessen our risk we can diversify among stocks that exist in different asset classes.
When we use different stocks in different asset classes to diversify we look at
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This level of diversification allows us to allocate our risk among companies that are different in scale, trade, and geographical location. In doing this we can mitigate many of the risks that come from investing. As mentioned previously, when we invest we are giving companies money in hopes that they are able to put our money into projects that produce revenues for the organization and investment returns for us. However, when we invest this money we are given no guarantee that we will see any investment returns. By spreading our money around to companies that are located in different areas of the globe and work in different areas, we provide security should one industry or region fall under intense scrutiny. For example, market factors may cause small technology companies to fall out of favor.That being the case, we would want to make sure that our portfolio consisted of companies outside of the technology industry. Again, to offset the losses we experienced from owning stock in small tech firms. The same holds true for companies outside of the United States. To protect our portfolio from significant losses when the U.S. economy goes through a downturn we can soften our losses by owning stock in companies that operate outside of the U.S. Most well diversified portfolios now include international stock in them.
Lastly, we are able to further protect our portfolio from stock market downturns by expanding outside of just stocks. Diversifying using multiple investment options (stocks and bonds) that perform different under different market conditions adds an additional layer of protection to our portfolio. Generally speaking, when the outlook for the stock market is grim, people begin moving their money into safer investment securities such as bonds. The safety comes from the fact that bonds are a promise to pay back your principal plus interest. For example, if the government needed to raise money to finance a project they may offer an interest rate of 4% over a ten year period to attract investors. The government is saying that in exchange for your investment, they are willing to pay the full amount, plus 4% interest back to you over the next ten years. Not much different from how the banks lend money.
As the stock market goes through a cycle and has a few bad years, bonds tend to remain stable, softening the blow we may have felt with a portfolio consisting of only stock. However, while bonds carry less risk than stocks and create greater stability for our investment portfolio, it is important to remember that in exchange for a safer portfolio, we are giving up some of our potential for larger gains.
Seem a little overwhelming? Don’t worry. Luckily, there are people who are well compensated to put together diverse portfolios for investors. The easiest way to obtain a well diversified portfolio is through a mutual fund.A mutual fund invests in many different underlying securities. Each mutual fund has a stated objective which serves as a guideline to how and why the underlying investments have been selected. The stated objectives of a mutual fund allow us the ability to find and invest in funds that focus on different asset classes.
For instance, some funds may be classified as:Large Cap Growth funds, investing in larger companies with the main objective being capital appreciation.
Others may be classified as:
International funds investing in companies overseas. There are many asset classes to choose from and, as mentioned earlier, diversifying among these asset classes is a significant step in putting together a proper portfolio. To make this process easier (and less stressful) on investors, companies have developed mutual funds, called asset allocation funds that diversify one’s investment among different asset classes. Asset allocation funds provide a great avenue for “hands-off” investors who are seeking a fully diversified portfolio.
However, don’t forget that the most important thing for each investor to do is to determine what his or her investment goal is. After we have decided how much risk we are comfortable taking and what our overall investment goals are, we can research the mutual funds offered and determine which funds — investment objectives meet our investment goals.
John R. Ryan is the Regional Marketing Director of John Hancock Retirement Plan Services
Disclaimer: Before investing one should consult a registered financial advisor to obtain further information about investments and financial products.
