Two known facts about financial markets are 1) They're unpredictable - the movements of markets has been likened to a drunkard's attempts to find his way home (random walk theory), and 2) They're volatile - in The (Mis)Behavior of Markets Benoit Mandelbrot suggests markets are much more volatile than generally acknowledged by standard financial theories.
The corollary of all this is that 1) Mutual funds generally don't beat the market (in fact they generally underperform it after fees), and 2) The best safeguard against volatility is diversification, with the ultimate diversification being the purchase of index funds or ETFs.
Therefore the most important decision faced by investors is how to allocate their funds across the available categories / sub-categories of investment, the main ones being:
* Cash
* Stocks (domestic, international, blue chip, smaller companies, tech stocks, value stocks, income stocks, growth stocks...)
* Bonds (government issued, corporate, high-yield/high-risk/junk bonds)
* Index-linked funds
* Real estate (direct - buy/flip, rental units; indirect - REITs)
* Commodities
* Derivatives
* Specialist investments (antiques, art, wines...)
It's important to keep some easily accessible rainy-day money in the form of cash. But while your capital sum is (generally) safe its value is being eroded by inflation, ie $100 10 years ago would buy more than it does today.
Stocks have traditionally been the engine of growth returning in the region of 7%pa long term. But even within the broad realm of stocks there are numerous varieties as indicated above.
Bonds, especially government issues, are safer than stocks but unless they are help until maturity still carry some risk as their value rises and falls in the opposite direction to interest rates and expectations.
For the risk-averse the "safest" of the above is the index-linked fund, which guarantees your funds will keep their absolute purchasing power. However, you still run the risk that other investments will far outperform tame inflation trackers.
Index investing is the safest way to take advantage of market growth, but it can seem a little bland. You can spice up your portfolio by some direct investment in some personal choices, eg investing in your favorite store. You can do easily this through cheap execution-only online brokers. But don't place too much money in too few stocks.
So how do you determine the best allocation of your assets. There is no single right answer for all folks. The right balance for YOU depends on 1) YOUR personality, and 2) YOUR goals (and their timeframes).
Your personality determines the amount of risk you're comfortable with. The higher the risk, the higher the (expected long-term) returns. But if you can't sleep at night go for a safer, lower-yielding option. Your personality may also suggest some preferences that are close to your heart, eg you may have a love of Asia, or railroads, or... and want to feel you on a piece of the action. Just don't let your emotions overrule logic.
We all have financial goals - usually several of them - and each with its own timeframe and priority. Examples are a holiday, car, house deposit, kids' college fees, a passive income, a comfortable retirement...
Each goal contributes to how you distribute your assets in proportion to its importance and the size of sum required. Generally, the longer term the goal, the more you can afford to take risks. If you're 20 and building a retirement plan you can be quite aggressive. If you're saving for a holiday in 6 months time you're probably better off in cash. As retirement is one of the biggest goals for most people so portfolios tend to get less risky as the holder ages.
As well as the risk/reward profile of each portfolio element you should also consider how closely they are correlated with one another, ie how much they move together. The textbook example of negative correlation is the ice cream maker and the umbrella factory. If one's doing badly, chances are the other is doing well. EG Stocks and real estate often move independently of each other so together form a good mix.
Matching your investments to your goal can also provide a degree of hedging. If you're saving for a house deposit, REITs should move with overall real estate prices. If you're hoping to move to, say, Mexico, having some Mexican holdings will help your money maintain its value in your intended destination.
Over time your goals will change, some will be fulfilled or dropped, others will emerge. Also some assets will do better than others. Therefore you should re-assess your asset allocation every so often. Once or twice a year makes sense. However, avoid making lots of minor changes, you'll just spend a fortune in fees.
By J Finnis
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