Intro to Investing (asset allocation, stocks, bonds and more!)

After understanding where you should put your money, you need to know WHAT to put it in.  The ‘what’ question is first one of ‘asset allocation’, which is just a fancy way of saying what kinds of things you should buy as investments.  These categories, or ‘asset classes’, are broadly defined as either financial instruments (stocks, bonds, cash) or property (real estate, gold coins, mint-condition Amazing Spider Man comics.)

Spidey notwithstanding, the only categories you really need to consider* are stocks, bonds, and cash instruments (savings accounts/CDs/money market funds.)  These 3 asset classes span the gamut of risk-reward such that you can use a combination of them to plan for ALL of your financial needs.  In general, the more ‘risk’ (how much the value of your investment goes up and down over time) in an asset class, the higher the expected return.  Therefore, one would expect stocks, the most volatile investment, to have the highest rates of return, and safer things like bonds or cash to have the lowest.

If you look at the graph below, taken from finance professor Jeremy Siegel’s excellent book Stocks for the Long Run, that’s exactly what you’ll see.  The graph shows the total real returns for stocks, bonds, treasury bills (approximating money market funds or CDs), gold and cash (= money earning 0% interest, like your checking account.)  ‘Real’ means that these returns are adjusted for inflation, a force which eats away at the spending power of your money.  This is an important adjustment because what you really care about as an investor is how much stuff you can buy with your dollars, not simply how many bills you have.

From this we can see that ultra-safe treasury bills would’ve increased your savings by 300 times, with pretty-safe bonds increasing them over 1000 times.  This sounds pretty good until you look at stocks, which increased the purchasing power of $1 by over 755,000 times, or 755 times that of bonds.  This incredible result demonstrates the power of stocks as a long term investment vehicle.

For this reason, I recommend that any savings you don’t need in the next 5 years be placed in stocks.

You might be a little more conservative with this rule if you were approaching retirement and all of your wealth was tied up with investments.  In that situation you might then extend the time frame rule of thumb to money you don’t need in the next 5-10 years.  Keep in mind though that if you can afford to take a little more risk (like if your house is paid off and/or you have some fixed income in the form of a pension or a healthy amount of social security), on average it pays to weight your portfolio more towards stocks.

There are some important conclusions from this rule: if you’re still 5-10 years from retirement, ALL your retirement funds should be in stocks.  When you’re young, and even middle-aged, you need to be aggressive in your asset allocation by putting your wealth into stocks.  Yes, stocks go up and down a lot in the short run, but in the long run, they clearly outperform everything else.

Say you’re 30 years old and plan on retiring at 65.  If you have a portfolio that represents the entire stock market and the market gets cut in half tomorrow, should you lose any sleep?  Absolutely not!

What does it matter to you what happens to the stock market in the next 30 years as long as you insure yourself against permanent loss by having a well-diversified stock portfolio? (We’ll talk about the best way to diversify in the next article.)  All you care about is what the value of your investment is at age 65.  Anything that happens in between shouldn’t bother you one bit.  There’s an easy way to avoid this stress; don’t check your retirement balance more than once every year until you get close to retirement.  Instead, focus on what you can control and pump as much money as you can into your 401k/IRA.  (Calculate how much you’ll need to save here.)

As another ‘Stocks for the Long Run
‘ table shows below, real stock market returns have been an incredibly robust ~7% per year through periods of war, depression, oil shortages, double-digit inflation, terrorist attacks, and industry bubbles.

Hopefully by now I’ve convinced you of the absolute necessity for your long-term money to be in stocks.  That still leaves the question of short- and medium-term (< 5 year) savings.  For these savings, you want a stable investment so that you’ll know how much money you’re going to have by the time you need to use it.  As you can see below, stocks almost always outperform bonds over long time periods, but not as much over short ones.

Short-term savings (< 1-2 years): Use an online high-interest savings account like this one from INGDirect (or find one on bankrate.com.)  High-interest savings accounts typically return about 5 times the interest of a brick and mortar savings account.  Plus, ING allows you to create multiple accounts to track each of your short-term savings goals (travel fund, plasma TV, emergency money, etc.)  You can setup automatic deductions from a checking account to fund these savings goals on a regular basis.  Say you want to save $4000 for a trip to Europe one year from now.  Divide the amount of money you need by the months until you need it.  In this case, that would be $4000/12 months = $333 per month.  That’s how much you need to save each month to hit your goal.

Medium-term savings (1-5 year): If you really want to optimize your savings, use a bond index fund like Vanguard’s VBMFX for medium-range goals.  The reason for adding this complication is because bond funds typically earn a couple of percentage points more than high-interest savings accounts, in exchange for a small amount of volatility over time.

If it sounds overly complicated to have separate types of funds for short- and medium-term savings, make life easy for yourself and just use a high-interest savings account for medium-term savings goals as well.  These might include your future wedding expenses or a house downpayment.  Use the same calculation for medium-term goals as I demonstrated above for short-term ones.  These are really important (and simple) calculations to do; they often show you that you need to start saving more money each month than you already are.  (Start here to get 30 excellent tips that can save you big bucks.)

Summary

Now that you know how to allocate your assets, you need to know exactly what to invest in.  I answered that in this post for short- & medium-term investments (< 5 years.)  I showed you that for long-term investments, stocks are clearly the way to go, but the question remains, how should you go about investing in stocks?  Should you buy that hot mutual fund you read about, or maybe individual stocks like Google or Walmart; what about investing in foreign companies versus US-based ones?

Read the next article for what may be the only long-term investment choice you’ll ever need.

* Many people might clamor for real estate to be added to this list.  Contrary to popular opinion, real estate has been a terrible investment over long periods of time, appreciating roughly with inflation (ZERO real return.)  From 1975 – 2008, real estate appreciated at real return of 1% per year, versus 2% for risk-free treasury bills and 8% for stocks.  Owning property means paying many expenses like property tax, homeowner’s insurance, maintenance and large transaction fees (like closing costs of ~6% when selling your home.)  Also, real estate is very illiquid, meaning it is hard to turn it into cash; the only way to do so is to sell it.

If you needed money in a hurry you can sell your stocks anytime the market is open instantly for about $10 per trade, whereas your house could sit on the market for months and not sell.  You should treat a potential home purchase as a place to live, NOT as an investment.  Even if you plan on buying property to rent it out, you still have to play landlord, or pay someone else to do it.  Buying a stock index fund, on the other hand, allows you to sit back and do next to no work while your money grows exponentially. [Back to where you left off]

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9 Responses to “Intro to Investing (asset allocation, stocks, bonds and more!)”

  1. Ed Says:

    Numerous advisors suggest using REITs for real estate holdings. They are very different from owning property directly, especially with respect to liquidity. There are also real estate ETFs now. What you wrote about long-term performance may apply to those as well, but it still may be another asset class to consider.

    Good blog!

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