“There are risks and costs to a program of action, but they are far less than the long-range risks and costs of comfortable inaction.” John F. Kennedy , Thirty-fifth President of the United States of America.
Risk, in our daily lives we do everything we can to mitigate or decrease the amount of personal risk were exposed to. Generally, we attempted to diminish risk in all aspects of our lives: from insuring our homes, cars, collectables, health, livelihood, and indeed our lives; to wearing seatbelts, adhering to medication prescriptions, and following work place safety guidelines. We are risk adverse society! However, many of us ignore risk to our financial well being, we over utilize credit, fail to budget our finances, and neglect to adequately plan for our future.
For investors, shirking our responsibility to acknowledge risk can often lead to calamity. There are several areas of investment risk that seemingly go unattended by many investors. In my earlier article “Investing 101: Getting Your Feet Wet (the basics), I addressed the Risk Pyramid and suggested an approach for new investors to utilize to mitigate risk based upon the different risk levels associated with varying types of asset classes. Here we will discuss the importance of investment diversification among these asset classes.
I can think of no better quote than the one above to summarize the importance of diversification in our investment portfolio. It is an easy thing to purchase a mutual fund, or a few stocks of well known companies. There are investment platforms available on-line where a person can register, fund their account, select stocks or mutual funds, and over the course of only a few moments feel warm and lit up inside knowing that finally they are investing for their future. This to be sure is a program of action. However, not one that I would recommend, as it is certainly not a well thought out plan of action.
As is common with many endeavors, we are most vulnerable to mistakes when we approach them with the disadvantage of inadequate knowledge, and experience. When learning to pilot an aircraft we are not typically handed the keys without first having some level of knowledge of the principles of flight. Without knowledge, and experience in the principles of personal investing, we lack the ability to have foresight of the perils that may lay ahead.
There are several advantages related to improving our level of investment diversification: it allows us to decrease risk by not focusing our resources into a single asset type (a.k.a. keeping your eggs in one basket), utilizing differing asset classes ensures exposure and / or protection from varying market cycles and market environments, and finally it is believed by many investment professional that asset diversification will increase your level of return on investment.
A quick review of the Risk Pyramid identifies these varying asset classes: the lowest risk in the bottom one-third, US Treasury Bills, US Treasury Bonds, CD’s, Money Market Funds; the middle one-third contains Federal Agency Bonds, Conservative Bonds, Municipal Bonds, Balanced Mutual Funds, Index Funds, and Blue Chip Stocks; the top one-third contains International Bonds, Rental Income Properties, Growth Stocks, Foreign Stocks, Collectables, Junk Bonds, and New Ventures. Investment risk increases as you go up the pyramid!
One example in spreading ones risk through these varying asset classes is utilizing a 40-40-20 approach. That is, 40% of your investment funds placed in stocks, 40% of your funds invested bonds, and 20% in cash (assets listed at the bottom third of the Risk Pyramid). This level of risk profile would be typical for someone who possesses an appropriate level of understanding of each of the asset classes in the Risk Pyramid. For investors who are very new to investing, those just starting out, or with less than one year of experience might be better suited to a higher allocation to cash assets. Review my above mentioned article (Investing 101) for more information.
When formulating the level of diversification you wish to achieve among asset types you might also wish to utilize a sliding scale of a percentage in each of the three asset types (stocks, bonds, cash) based upon several factors. Circumstances which might influence the percentage of funds you hold in each asset class might include: the investors age, finances, and investing goals. One example would be, exposure to assets further up the Risk Pyramid decreasing over time, the closer an investor gets to their retirement the lower their exposure to the upper two thirds of the Risk Pyramid. For long term investors this sliding scale might be: 50% – 80% stocks, 20% – 40% bonds, and 10% – 25% cash.
As I began my investment experience I determined that I would prefer to protect my assets from risk during the first two years of my endeavor. To do so I decided to utilize the learn and invest approach. I invested 70% of my money in the asset types found only in the bottom one third of the Risk Pyramid, and 30% in the middle third of the pyramid. As I accumulated knowledge and experience I adjusted my exposure to risk by increasing the percentage of money invested in the middle third of the pyramid.
This approach allows you to develop the level of knowledge needed to increase your ability to invest in higher risk profile investment vehicles, while building a strong base of assets with minimal risk. Upon reaching a level that you feel competent to increase your risk exposure you will have adequate resources available to employ in higher risk investment types. Very much akin to a flight school for investors.
In addition to diversifying across asset classes, the prudent investor will farther mitigate risk by diversifying within each asset class. Utilizing various sized mutual funds and stocks (small cap, mid cap, large cap stocks), bond types, and cash investment vehicles, are avenues to heighten diversification. I will address these important issues in my next article on investment diversification.
The Latin Poet Horace wrote, “The power of daring anything their fancy suggest, has always been conceded to the painter and the poet.” Did you notice that he left investors out of his prose? In the pursuit of investing one’s hard earned money risk will always play it’s part, it is the investors job to utilize risk with prudence in endeavoring to maximize their gain.