In my Investing 101 post, we talked about the basics of investing. We briefly covered the history of the stock and bond markets, which has led to ever complicated financial products. We also delved into the basic components of investing. This led to discussing the pros and cons of the basic investment products, as well as the risk and reward tradeoffs of each.
With these basics out of the way, I can talk about the most common question my clients have. How do I invest my money? The answer will always be, “That depends.” You see, everyone has their own unique wants, dreams, and goals. There are as many different investment strategies as there are people.
Most people simply say that they want to make money. Wanting to make more money doesn’t mean you will make more. Investment products each have their own unique goals. Some are for short timeframes, others focus on specific markets, while some simply replicate the economy. There are tens of thousands of investment options out there, and each one could be the right solution for an investor. As a financial advisor, I plan first and invest second. Investments follow an investment strategy.
Diversification is a buzzword in the industry. People hear it all the time, but do they know why? Sure, it means that you’re not putting all your eggs in one basket. Wait, didn’t Mark Zuckerburg put all his eggs into the Facebook basket? He sure did, and he did pretty good for himself. Actually, he did very well when you consider what happened to all the other dot com investors that failed to achieve success. Now, I’m not saying you can’t make a ton of money investing in a single company; I’m saying that odds are against you.
How do I approach the markets? I start by conceding that I have no idea what the future holds. This has turned some people off… “But you’re a Certified Financial Planner, you’re supposed to know this stuff.” That’s true, I am an investment professional. I know the markets far better than most. That still doesn’t give me the ability to predict the future. No one can.
To prove this fact, all I need to do is look at the experts leading up to 2008. Wall Street helped collapse the economy with the products their ‘experts’ created. ‘Experts’ sold hundreds of thousands of people stuff they couldn’t afford. People were told by ‘experts’ that real estate could never go down in value. Most of these so-called experts are just salesmen. Their confidence sold people; never believe anyone who guarantees the future.
A true expert won’t try to sell you on an investment’s future. Instead, they’ll look to the past. Below is a chart showing how various business sectors ranked over a decade.
You can take any decade in history and see a similar hodge podge of color. Based on the history of the markets, the best answer one can give about the future direction is, “I don’t know.”
This is where diversification saves the day. Diversification is when you invest in different asset securities in an attempt to reduce overall investment risk in a portfolio. While you cannot predict the future, history has shown that when one type of investment does well, another will be doing poorly. Diversification is all about balancing investments. Your advisor’s job is to build your portfolio and to ensure it stays diversified properly over time.
Products, Products, Products
We started talking about stocks and bonds. Nowadays, we have mutual funds, exchange traded funds, actively and passively managed funds, closed ended funds, real estate investment trusts, fixed and variable annuities, and so on and so on. A bank might offer you a certificate of deposit, a money market, or maybe even a fixed income mutual fund. An investment company can offer you several hundred mutual funds or ETFs. Your insurance company might recommend whole or term life. Eventually, you’ll hear about retail accounts, IRAs, Roths, HSAs, FSAs, 401ks… at some point, it becomes a jumble.
Why are there so many of these products? The quest for diversification is one of the main drivers here. Cost has been an additional concern. In Investing 101, we talked about fundamental investments: stocks and bonds. In order to have a minimally diversified portfolio, you would need to invest in at least 20 different individual securities. Decades ago, this is what most investors needed to do.
There are more than a few problems with using individual securities to invest. The first is time. It takes time to learn about a company you want to invest in and it takes time to make sure the company is performing well enough to hold on to. The next issue is cost. You have to pay a commission every time you buy and sell an individual security. How expensive is that? Rebalancing the portfolio could easily cost you $1,000 every year.
Saving time and money was what led to the birth of packaged products. The first of these products started early in the 19th century. These were known as close ended investment companies. In 1928, the first mutual fund went public. The market collapse that started in 1929 led to the closure of most of the close ended funds, which provided an opportunity for mutual funds to grow in the market. At first, these investment pools were actively managed by professionals. Over time, some funds found it cheaper to simply replicate an index like the S&P 500.
The evolution towards package products allowed people to pool their money together, which reduced the cost of investing. It also allowed clients to diversify their investments to a higher degree. Rather than just 20 or so stocks, investors could hold onto hundreds of different company’s stocks or bonds. These packaged products come in every imaginable niche. There are over 10,000 mutual funds in the U.S. alone, not to mention the countless other investment products available. Each has a specific purpose and goal, and all of them can be used in your portfolio.
How do I invest my clients?
Every client has uniquely personal needs and wants. No two portfolios should be the same. A portfolio should match the goals and timeframe of the investor. The investments should be scalable as well. A simple mix of mutual funds may work well for novice investors with smaller accounts. As a client becomes more comfortable with the markets and their accounts grow, additional layers of investments are added to ensure diversification. Below is an example of a typical client’s investment portfolio.
When I talk to people about a well-diversified portfolio, I ask them to picture a Ferris wheel in their mind. A portfolio should look and act similar to a Ferris wheel. Instead of putting all your money in one bucket on the wheel, we diversify the portfolio by spreading the money around. Just like a Ferris wheel, the economy is always rotating. A business or sector may be at the top one year, only to find itself at the bottom the next.
This is where rebalancing comes into play. Basically, I take the money on top and move it to the bottom. I know that investments at the top will eventually go down, and I know that a sector at the bottom will start going up. I just don’t know when. My job it to take the emotion out of investing. On a quarterly basis, I rebalance my portfolios to the determined level. That means I sell what’s done well for the quarter, and buy what hasn’t (Sell high, buy low). This keeps a hot market sector from dominating the portfolio. Think back to the tech bubble… how much did people lose when their tech dominated portfolio burst?
This all sounds pretty simple. Why would anyone hire an advisor then? For some folks, I’ve recommended simple solutions that cost far less than my services would. For others, there’s quite a bit more an advisor can do for them. I obviously find value in the services I provide. In my next article, I plan to discuss the value of working with an advisor.