For the past couple of weeks, we have chronicled the steps that new investors should take to begin investing for the long term. Review those Blogs if you are catching up and interested in one of the most important aspects of “adulting” – preparing for personal long-term financial independence. Today we further explain the reasoning behind our recommendations in the last two Blog entries.
Last week we addressed investors who have accumulated between $50k and $100k in long-term investment assets. While technically no longer ranked novices, these people are unlikely to have a good understanding of the fundamental goals of portfolio diversification. In a previous Blog, we addressed the “why” aspect, so today we will begin explaining the “how.”
As we noted last week, the investing universe is comprised of 7 fundamental classes of assets; Domestic Stocks, Domestic Bonds, Foreign Stocks, Foreign Bonds, Cash (and Equivalents), Real Estate, and Hedges. Most are self-explanatory, and we will deal with hedges in a future Blog.
“How” to include more Asset Classes in a portfolio requires an understanding of some basic mathematical principles. In this case, the term in the spotlight is “correlation.” When two variables move together, they are called “correlated.” The closer movements are to each other over time, the higher the correlation. When two variables move in opposite directions, they are called “inversely (or negatively) correlated.” The “correlation coefficient” scale runs from -1.0 to +1.0. A diversified portfolio seeks to achieve a correlation coefficient that is low, or even negative.
As markets move, a low correlation means that as some items go down in value, the portfolio does not go down as much, if at all, because other assets may rise. Over time, multiple Asset Class portfolios will generally experience smaller losses then a 100% stock portfolio. When resultant declines are lower, and the recovery period shortened. Regaining lost ground quickly is the essence of long-term successful investing success.
The novice investor who has accumulated shares in a broad market Exchange-Traded Fund (ETF - see last week’s Blog for explanation) is participating only in the first Asset Class, Domestic Stocks. Somewhere between account values reaching $50,000 and $100,000, it is time to add at least one other Asset Class. As discussed last week, this is generally done by introducing bonds in the portfolio.
We also mentioned that our current interest rate environment is not conducive to holding a large percentage of bonds. Therefore, to enhance diversification, we must choose yet another Asset class. Right now, we are interested in Foreign Stocks. Again, we are not suggesting placing a large percentage of Foreign Stocks in a portfolio; about 10% is enough to influence results.
In the Foreign Stock Asset Class, we often use actively managed mutual funds, as fund managers have more time and expertise to make their stock selections. When contemplating any mutual fund, be sure to do some research. Begin by only looking only for “no-load” funds, meaning there is no sales charge to buy or sell shares. Look at the track record of the managers, the reputation of the affiliated company, and the internal costs of the fund itself. There is much to learn, but learning and adhering to the fundamentals will improve your chances of success.
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