About diversification that is.
The key to successful investing is to diversify and rebalance. You’ve got to know when to sell as well as when to buy. Anyway, it turns out that mutual funds are the perfect way for most of us to build beautifully balanced portfolios that in the long run will make us money.
So how do we do it? The first thing we need to do is to decide on the asset classes. I like to break it down into five classes: Domestic Stocks, International Stocks, Bonds, Real Estate Investment Trusts (REITS), and Commodities.
Within these classes we can break it down further into subcategories. Under domestic stocks, we find Large Cap Value (often identified with so-called Blue Chips), LC Growth, Small Cap Value and SC Growth. International stocks can be similarly broken down and we can add in emerging markets.
Bonds come in three basic flavors: Government (U.S. and Municipals, often tax free), Corporate and Foreign. Real Estate, of course, can be personal or commercial, but for portfolio construction, I generally stick to commercial Real Estate Mutual funds or REITS. Commodities are those famous pork bellies, cotton, metals, corn, and the like.
Next, it’s time to determine how much to put into each class. This will vary according to your goals, your time line, and your risk profile. I recommend you work with your personal financial advisor to determine the proper percentages to allocate to each class. We whiz-bang advisors call this an Asset Allocation.
Finally, choose your mutual funds. I generally use two, maybe three, funds in each asset category to get a broad spectrum of managerial expertise. It’s all about the right team. Note that my portfolio now is diversified in two ways: across many asset classes and with mutual funds which, by definition, invest in many different securities. I’m spreading my risk.
Of course, just buying and holding isn’t the end of the game. You must periodically rebalance your portfolio in order to maximize your investments. So, for example, if 25 percent of my portfolio should be LC Domestic Value Stocks but that allocation has grown to 35 percent of my portfolio, then mathematics in our universe decrees that some other combination of securities must be at least 10 percent lower.
So it’s time to sell the LCV and buy the other securities to bring my portfolio back to equilibrium. I’m selling high and buying (relatively) lower.
Next time: There’s no free lunch. How much do mutual funds cost?
Michael Terry is a financial planner who specializes in objective and independent advice.