This is continuation of our last post.
Fine-Tuning Your Portfolio
Once you’ve made the big decision as to what your stock/bond allocation should be, it’s time to do your fine-tuning.
Just as stocks and bonds tend to poorly correlate, different kinds of stocks and different kinds of bonds similarly have limited correlation. That’s especially true on the stock side of the portfolio. Smart investors will make sure to have both domestic and foreign stocks, stocks in both large companies and small companies, and both value and growth stocks. Growth stocks are stocks in fast-moving companies in fast-moving industries, such as technology. Value stocks are stocks in companies that have less growth potential, but you may be able to get their stock on the cheap, at times making them better investments than growth stocks.
Just as you get more bang for your buck but also more bounce, with stocks versus bonds, you also get more potential return and additional risk, with small-company stocks over large-company stocks. Although international stocks aren’t any more volatile than U.S. stocks, per se, differences in exchange rates can make them much more volatile to U.S. investors. The greater your tolerance for risk, the more small-company stocks and more international stocks you might want to incorporate.
Once your portfolio grows, and you have all the broad asset classes covered, you might consider branching out into narrower (but not too narrow) kinds of investments. Possibilities would include high-yield bonds, small international company stocks, commodities and certain industry sectors of the economy, especially those that tend to have limited correlation to the market at large, such as real estate and energy.
The Mechanics of Investing
It is very hard to achieve good diversification, the kind described above, by investing in individual securities. “Unless you have a ton of money, it is impossible to own a sufficient number of stocks so as to be diversified across the board…domestic and international, companies of different sizes, and different industries. Owning mutual funds or exchange-traded funds makes achieving good diversification much easier,” says advisor Peters.
Exchange-traded funds (ETFs), are akin to index mutual funds, but they trade like stocks. You’ll pay a commission to buy an ETF, so mutual funds generally will make more sense if you are contributing regular small amounts to your account. When picking a mutual fund or ETF, you not only want to find one that represents a certain broad asset class (such as large American stocks, for example), but you want one with reasonable expenses and a solid management team.
One caveat: Pay little attention to which asset class happens to have run away in the past months. The vast majority of investors make the mistake of pouring money into “hot” sectors, and then selling off when those sectors cool. They are continually buying high and selling low…exactly the opposite of what you should do!
“Pick an allocation and stick with it,” says Johnson. “Don’t forget your goals. Don’t panic and sell when the market drops. To reap the maximum rewards from the markets, you need to ride out the lows and wait for your day to come.” She also cautions against market timing. “The best time to invest is always right now,” she says. “Lots of people sit on the sidelines, keeping their money in cash, waiting for the right moment to buy. That’s a mistake. You stand to lose more than you stand to gain.”
Johnson points out that idle cash loses money to inflation. Any money you won’t need for the long-haul is best invested.
Keeping An Eye on World Affairs
When things get out of whack, you’ll need to rebalance and get back to your original allocation. Most financial experts recommend that you look over your portfolio either once a year or once every year and a half.
If the urge strikes you to shuffle things around much more often than that, resist! “Buy and hold investors tend to be the most successful investors over the long run,” asserts Johnson.