Monday, January 16, 2006
Use Diversification to reach your Personal Finance Goals
All investors must face risk when investing. There is no way around it. Fortunately, a simple common sense adage can greatly reduce the amount of risk you expose yourself to. That saying is “never keep all your eggs in one basket” and it refers to the investment strategy of portfolio diversification. Anyone who is serious about their personal finance should understand and utilize diversification in their investments. I will explain why.
When a novice investor finds an amazing opportunity to invest, the first thing that likely crosses his or her mind is to put everything they can afford into the investment. This is the wrong course of action to be taking. Equity investments are never guaranteed. No matter how good a stock may seem anything truly can happen. If you need proof of this, realize that no one ever invests in a stock because they imagine it will decrease in value. Yet, tons of people (possibly including yourself) have and continue to lose piles and piles of money in the stock market everyday. More so, even investors who realize great returns year after year own some stocks that have fallen in price. The secret of those who are able to realize a positive return with their portfolios while still holding on to “loser” stocks is those who are successful do not have all their eggs in one basket.
The concept behind having a diversified portfolio is that by hold a variety of equity and debt instruments no one event can completely diminish your wealth. A New York stock market crash would not be felt as harshly if a variety of bonds and stocks from other countries were held in one’s portfolio. By reducing the risk, reaching your personal finance goals will become easier and much less stress inducing.
In the past, Mutual funds where hailed as the best and easiest way to make your portfolio diversified. A mutual fund is a collective investment that invests the combined “pool” of investment capital in a variety of stocks, bonds, money market instruments and other securities. Investors purchase “units” in mutual funds. Dividends and other profits are divided up and doled out per unit. Investors in mutual funds are able to experience the positive effects of diversification while only having to pay indirectly for the large portfolio of investments. Mutual funds have come under some controversy. Fund managers run and control mutual funds. What qualifications does one need to run a mutual fund? In fact, the answer is none! People who have no track record in finance (or even a losing one) run some mutual funds! Another negative aspect of mutual funds is the purchase fees and sales charges (known as the load) that investors are exposed to. Mutual funds are businesses and they make money by getting more customers. By making customers pay a fee (usually .5-5% of the total invested, but it can legally be as high as 8.5%) mutual funds are able to remain profitable to maintain, regardless of their performance! Part of the fees paid by investors goes towards marketing budgets, which try and attract more investors to the fund. Mutual funds companies have also come under fire for using unethical marketing techniques to “fudge” performance numbers of funds to make them seem more attractive. Perhaps the most upsetting aspect of mutual funds is that most do not achieve results that meet or beat the market as a whole. 80% of mutual funds (according to investopedia.com) fail to even match the stock market’s performance every year. At the end of the day, you are paying a business a fee to put an unqualified person in charge of your money so that he or she may give you a return that does not equal the stock market’s average return. Doesn’t make a lot of sense, does it? Thankfully there is an alternative.
Exchange Traded Funds (ETF) are similar to mutual funds in terms of benefits, but do not include many of the disadvantages associated with them. ETFs are index funds. That is, they represent a basket of stocks on a particular exchange. Popular indexes include the S&P 500 and the Dow Jones Industrial Average. Like mutual funds, investors are able to enjoy a diversified portfolio at a fraction of the cost! Furthermore, long-term investors do not have to worry about making consistent decisions and actively trading. Past performance indicates that the stock market has a 10% return annually. Owners in ETFs are able to realize these returns without having to make any decisions. Furthermore, because ETFs are indexes, they do not need to be actively managed. Management fees on ETFs are much lower then comparable mutual funds. ETFs are the perfect investment for those who want to realize the long-term growth of the stock market without having to actively participating.
No one should invest solely in ETFs, because a person would still not be diversified. Cash, debt and equity instruments should be apart of everyone’s portfolio. The exact amount of each depends on each individual’s goals, expectations and risk tolerance. Regardless, everyone should have a general idea of the percentage each category should make up of their portfolio to align with one’s goals and risk tolerance. For younger investors the portfolio makeup that is often suggested by personal finance experts consists of 70-80% equity investments (stocks), 5-20% debt instruments (bonds, GICs) and 5-20% cash. Even within your investment categories, do not forget to diversify! Your equity investment portion is suggested to consist of somewhere between 30-60% foreign content (stocks from other countries). I must reiterate, this is only a suggestion but each situation is different. There is by no means one correct allocation for everyone. Speak to personal finance professionals whom you trust for more personal advice. Good luck diversifying your portfolio!
When a novice investor finds an amazing opportunity to invest, the first thing that likely crosses his or her mind is to put everything they can afford into the investment. This is the wrong course of action to be taking. Equity investments are never guaranteed. No matter how good a stock may seem anything truly can happen. If you need proof of this, realize that no one ever invests in a stock because they imagine it will decrease in value. Yet, tons of people (possibly including yourself) have and continue to lose piles and piles of money in the stock market everyday. More so, even investors who realize great returns year after year own some stocks that have fallen in price. The secret of those who are able to realize a positive return with their portfolios while still holding on to “loser” stocks is those who are successful do not have all their eggs in one basket.
The concept behind having a diversified portfolio is that by hold a variety of equity and debt instruments no one event can completely diminish your wealth. A New York stock market crash would not be felt as harshly if a variety of bonds and stocks from other countries were held in one’s portfolio. By reducing the risk, reaching your personal finance goals will become easier and much less stress inducing.
In the past, Mutual funds where hailed as the best and easiest way to make your portfolio diversified. A mutual fund is a collective investment that invests the combined “pool” of investment capital in a variety of stocks, bonds, money market instruments and other securities. Investors purchase “units” in mutual funds. Dividends and other profits are divided up and doled out per unit. Investors in mutual funds are able to experience the positive effects of diversification while only having to pay indirectly for the large portfolio of investments. Mutual funds have come under some controversy. Fund managers run and control mutual funds. What qualifications does one need to run a mutual fund? In fact, the answer is none! People who have no track record in finance (or even a losing one) run some mutual funds! Another negative aspect of mutual funds is the purchase fees and sales charges (known as the load) that investors are exposed to. Mutual funds are businesses and they make money by getting more customers. By making customers pay a fee (usually .5-5% of the total invested, but it can legally be as high as 8.5%) mutual funds are able to remain profitable to maintain, regardless of their performance! Part of the fees paid by investors goes towards marketing budgets, which try and attract more investors to the fund. Mutual funds companies have also come under fire for using unethical marketing techniques to “fudge” performance numbers of funds to make them seem more attractive. Perhaps the most upsetting aspect of mutual funds is that most do not achieve results that meet or beat the market as a whole. 80% of mutual funds (according to investopedia.com) fail to even match the stock market’s performance every year. At the end of the day, you are paying a business a fee to put an unqualified person in charge of your money so that he or she may give you a return that does not equal the stock market’s average return. Doesn’t make a lot of sense, does it? Thankfully there is an alternative.
Exchange Traded Funds (ETF) are similar to mutual funds in terms of benefits, but do not include many of the disadvantages associated with them. ETFs are index funds. That is, they represent a basket of stocks on a particular exchange. Popular indexes include the S&P 500 and the Dow Jones Industrial Average. Like mutual funds, investors are able to enjoy a diversified portfolio at a fraction of the cost! Furthermore, long-term investors do not have to worry about making consistent decisions and actively trading. Past performance indicates that the stock market has a 10% return annually. Owners in ETFs are able to realize these returns without having to make any decisions. Furthermore, because ETFs are indexes, they do not need to be actively managed. Management fees on ETFs are much lower then comparable mutual funds. ETFs are the perfect investment for those who want to realize the long-term growth of the stock market without having to actively participating.
No one should invest solely in ETFs, because a person would still not be diversified. Cash, debt and equity instruments should be apart of everyone’s portfolio. The exact amount of each depends on each individual’s goals, expectations and risk tolerance. Regardless, everyone should have a general idea of the percentage each category should make up of their portfolio to align with one’s goals and risk tolerance. For younger investors the portfolio makeup that is often suggested by personal finance experts consists of 70-80% equity investments (stocks), 5-20% debt instruments (bonds, GICs) and 5-20% cash. Even within your investment categories, do not forget to diversify! Your equity investment portion is suggested to consist of somewhere between 30-60% foreign content (stocks from other countries). I must reiterate, this is only a suggestion but each situation is different. There is by no means one correct allocation for everyone. Speak to personal finance professionals whom you trust for more personal advice. Good luck diversifying your portfolio!
# posted by mikeyarmo @ 12:44 PM 
