Insights & Advice

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Stocks Have a Place in Everyone’s Portfolio. It Just May Not be First Place

You might think the sky had fallen given the coverage of global stock markets events in February and March. In hindsight, it neither heralded an end to world economies nor the beginning of another DotCom bust. It was simply a correction, although a painful one for those who were overly invested in stock markets.

In my last column, I introduced the concept of asset allocation—dividing your investment into asset classes like stocks, bonds and cash. A diversified portfolio would have sheltered you from the worst of the decline. During the market’s sudden break, U.S. Treasury Bond prices gained while corporate bonds, some mutual funds and even a few big, blue chip stocks fell less than the averages. Cash, in the form of money markets, was once again king and enabled savvy investors to take advantage of low prices.

So now that you’re a believer in asset allocation, how much should you allocate to each asset class? A standard rule of thumb is to put a percentage equal to one hundred minus your age (100-age) in the stock market and the rest in bonds with one to five percent in cash. A fifty-five year old plumber therefore would have 45% in stocks, 50% in bonds and 5% in cash. A thirty-three year old nurse might have 66% in stocks, 33% in bonds and 1% in cash.

The assumption behind this formula is that younger investors can afford to take more risks because they have more time to recoup any losses. Take the example of the DotCom bust at the turn of the century; many elderly investors lost fifty to seventy-five percent of their retirement savings gathered over a lifetime of hard work. A twenty-five year old may have lost an equivalent amount but has another fifty years to recoup her losses.

Stocks are your portfolio’s heavy hitters. They have historically had the greatest risk and highest returns among the three asset classes. That means you get the biggest bang for your investment buck over the long term from stocks but, as a group, they have lost money on average one out of every three years. So you need a long time horizon and a higher risk tolerance when investing in equities. Use stocks sparingly and select them carefully; or, as an alternative, I recommend investing in mutual funds.

These investments can reduce your risk somewhat while maintaining your returns because funds invest in a basket of stocks, if one stock strikes out the rest of the team can still win the game. Theoretically, professional fund managers are better at picking stocks then most of us because they spend much more time doing it. They also have the resources available to compete in a global arena. Of course you pay for all this expertise through upfront or inclusive fees and expenses and some managers and fund companies charge more than others.

Many investors argue rightfully that less than seventy-five percent of mutual fund managers consistently beat the indexes. Aside from reducing risk, why should we pay for mediocrity? My answer is that unless you have the time, money and knowledge to know all there is to know about each stock you invest in, you are better off in mutual funds.

Many individuals think that because they make a lot of money building houses, running restaurants, practicing law or medicine that they can do the same in the financial markets. Twenty years ago “dabbling” may have paid off, although I doubt it. Today, the global markets are just too sophisticated.

There is an alternative that combines the advantages of both stocks and funds.. Investors have ploughed over $450 billion into these vehicles last year and they are taking the investment world by storm. Called exchange traded funds, they will be the topic of our next column.

Posted in A Few Dollars More, Portfolio Advice