Diversification: Safety in numbers

"There are risks and costs to a program of action, but they are far less than the long-range risks and costs of comfortable inaction." John F. Kennedy , Thirty-fifth President of the United States of America.

Risk, in our daily lives we do everything we can to mitigate or decrease the amount of personal risk were exposed to. Generally, we attempted to diminish risk in all aspects of our lives: from insuring our homes, cars, collectables, health, livelihood, and indeed our lives; to wearing seatbelts, adhering to medication prescriptions, and following work place safety guidelines. We are risk adverse society! However, many of us ignore risk to our financial well being, we over utilize credit, fail to budget our finances, and neglect to adequately plan for our future.
For investors, shirking our responsibility to acknowledge risk can often lead to calamity. There are several areas of investment risk that seemingly go unattended by many investors. In my earlier article "Investing 101: Getting Your Feet Wet (the basics), I addressed the Risk Pyramid and suggested an approach for new investors to utilize to mitigate risk based upon the different risk levels associated with varying types of asset classes. Here we will discuss the importance of investment diversification among these asset classes.

I can think of no better quote than the one above to summarize the importance of diversification in our investment portfolio. It is an easy thing to purchase a mutual fund, or a few stocks of well known companies. There are investment platforms available on-line where a person can register, fund their account, select stocks or mutual funds, and over the course of only a few moments feel warm and lit up inside knowing that finally they are investing for their future. This to be sure is a program of action. However, not one that I would recommend, as it is certainly not a well thought out plan of action.

As is common with many endeavors, we are most vulnerable to mistakes when we approach them with the disadvantage of inadequate knowledge, and experience. When learning to pilot an aircraft we are not typically handed the keys without first having some level of knowledge of the principles of flight. Without knowledge, and experience in the principles of personal investing, we lack the ability to have foresight of the perils that may lay ahead.

There are several advantages related to improving our level of investment diversification: it allows us to decrease risk by not focusing our resources into a single asset type (a.k.a. keeping your eggs in one basket), utilizing differing asset classes ensures exposure and / or protection from varying market cycles and market environments, and finally it is believed by many investment professional that asset diversification will increase your level of return on investment.

A quick review of the Risk Pyramid identifies these varying asset classes: the lowest risk in the bottom one-third, US Treasury Bills, US Treasury Bonds, CD's, Money Market Funds; the middle one-third contains Federal Agency Bonds, Conservative Bonds, Municipal Bonds, Balanced Mutual Funds, Index Funds, and Blue Chip Stocks; the top one-third contains International Bonds, Rental Income Properties, Growth Stocks, Foreign Stocks, Collectables, Junk Bonds, and New Ventures. Investment risk increases as you go up the pyramid!
One example in spreading ones risk through these varying asset classes is utilizing a 40-40-20 approach. That is, 40% of your investment funds placed in stocks, 40% of your funds invested bonds, and 20% in cash (assets listed at the bottom third of the Risk Pyramid). This level of risk profile would be typical for someone who possesses an appropriate level of understanding of each of the asset classes in the Risk Pyramid. For investors who are very new to investing, those just starting out, or with less than one year of experience might be better suited to a higher allocation to cash assets. Review my above mentioned article (Investing 101) for more information.

When formulating the level of diversification you wish to achieve among asset types you might also wish to utilize a sliding scale of a percentage in each of the three asset types (stocks, bonds, cash) based upon several factors. Circumstances which might influence the percentage of funds you hold in each asset class might include: the investors age, finances, and investing goals. One example would be, exposure to assets further up the Risk Pyramid decreasing over time, the closer an investor gets to their retirement the lower their exposure to the upper two thirds of the Risk Pyramid. For long term investors this sliding scale might be: 50% - 80% stocks, 20% - 40% bonds, and 10% - 25% cash.

As I began my investment experience I determined that I would prefer to protect my assets from risk during the first two years of my endeavor. To do so I decided to utilize the learn and invest approach. I invested 70% of my money in the asset types found only in the bottom one third of the Risk Pyramid, and 30% in the middle third of the pyramid. As I accumulated knowledge and experience I adjusted my exposure to risk by increasing the percentage of money invested in the middle third of the pyramid.

This approach allows you to develop the level of knowledge needed to increase your ability to invest in higher risk profile investment vehicles, while building a strong base of assets with minimal risk. Upon reaching a level that you feel competent to increase your risk exposure you will have adequate resources available to employ in higher risk investment types. Very much akin to a flight school for investors.

In addition to diversifying across asset classes, the prudent investor will farther mitigate risk by diversifying within each asset class. Utilizing various sized mutual funds and stocks (small cap, mid cap, large cap stocks), bond types, and cash investment vehicles, are avenues to heighten diversification. I will address these important issues in my next article on investment diversification.

The Latin Poet Horace wrote, "The power of daring anything their fancy suggest, has always been conceded to the painter and the poet." Did you notice that he left investors out of his prose? In the pursuit of investing one's hard earned money risk will always play it's part, it is the investors job to utilize risk with prudence in endeavoring to maximize their gain.

Great investment strategies: Political endorsement of an industry

Political endorsement of an industry, and how you can capitalize from political capital. Is there really any doubt that if the next president is a Democrat alternative energy companies will see favorable legislation passed and signed which will increase their ability to produce clean energy, and thus increase their profits. Not in my mind!

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Mutual Funds Caught With Hands In The Cookie Jar?

Mutual Fund companies caught with their hands in the cookie jar? A recent article in the Journal of Indexes (July/August 2007, Hidden Fees Exposed!) cautioned that Mutual Funds were thought to be charging "Hidden Fees". The article goes on to explain the various types of fees that are frequently hidden. These fees are typically identified as various and sundry "fund agency costs", they are often obscured in a funds prospectus making them very hard to decipher. Thus the term "hidden". Say it ain't so, the average Joe investor takes it on the chin once again.

Agency fees, being the hidden nefarious pests that they are can often be difficult to quantify. However, it seems one ingenious professor has found a way to shed at least a sliver of light on this mystery. The Journal of Indexes article goes on to explain, "a group of professors led by Professor Rob Bauer figured a neat way to make an implicit measurement of their impact. Bauer et al, pulled together a study comparing the performance of mutual funds and traditional pension plans. Bauer's team found that mutual funds underperformed pension plans by a whopping 150 to 250 basis points (1.50% to 2.50%) per year." The study also found that Index funds lagged the pension plans by only 30 basis points. Additionally, it found "that direct costs only accounted for a slight difference in performance. They also believe that no real difference could be attributed to skill, because the funds and plans often had similar exposures, and in many cases identical managers. That left just one explanation for the lower fund returns- hidden fees."

Why would pension plans out perform managed mutual funds, and index funds? Well come to find out, size really does matter, fortunately pension funds quite frequently are large, their size creates pricing leverage which allows them to better negotiate investment terms with brokerages and other client services. No, you can't run out and create your own pension fund! But you can do the next best thing, utilize Index funds or Exchange Traded Funds (ETF's), both of which have noticeably lower fees than managed funds.

For the uninitiated, Index funds are investment instruments developed to match a tracking index such as: the S&P 500 Index, the Dow Jones Wilshire 5000 Index, and the Russell 2000 Index. An Index fund will hold roughly the same company's in it's fund as that of the index. Some of the more common Index funds are the:Fidelity Nasdaq Composite Index Fund, Fidelity Spartan Extended Market Index Fund, Vanguard 500 Index Inv, Vanguard Small Cap Index Inv, and the Vanguard Total Stock Market Index Inv. Index Funds typically have very low expenses, a check of the Vanguard Total Stock Market Index (VTSMX) at vanguard.com on (18July2007) found the expense ratio listed as .19%, that's below rock bottom.

Is there any wonder Warren Buffet wrote in his annual report from 1996, "Most investors, both institutional and individual, will find that the best way to own common stocks is through and index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals." In my not so lofty opinion, when a world class investor like Mr. Buffett takes time to advise individual investors they should sit up in their seats and listen. http://www.berkshirehathaway.com/1996ar/96arindx.htm l

Lets see what the much ballyhooed market madman Jim Cramer says about Index funds. In his book (Jim Cramer's Real Money, Ch 7, pg 185) he writes, "As I've said elsewhere, I am a rank conservative when it comes to retirement: I want the money as diversified as possible into high-quality equities as defined by an index fund or a mutual fund that acts as an index fund with a brain." So as to not take these remarks out of context Mr. Cramer is specifically addressing retirement accounts which he refers to as "too sacrosanct to play with".

There are reasons seasoned professional investors such as Warren Buffett and Jim Cramer would have you investing in index funds. Managed mutual funds carry a level of risk that index funds simply do not have. That is, the chance that the manager of the fund will make a mistake in how they configure the fund with assets in conjunction with the market environment. Markets are inherently volatile, even index funds carry risk that is levered to the whims of the market, political events, natural disasters etc. The added risk that funds would impose "hidden fees" is just one more factor that increases the risk on return to the average investor.

Please don't conclude that I am leveling the charge that all funds have hidden fees, that simply isn't true. However, identifying fees that are plainly stated on the most readable fund prospectus' can be a challenge to many investors, finding fees that are hidden could be an exercise in futility. Often in the realm of investing, minimizing risk is the individual investors only safe harbor. Index funds through good markets and bad will carry only the risk inherent to the market and it's whimsy.

"For indeed, the investor's chief problem - and even his worst enemy - is likely to be himself" - Ben Graham in his book The Intelligent Investor. What is the best way to invest your money for the future? That my friends is what is commonly referred to as a loaded question. You might say it's really not that complicated, oh the woe of the many who have uttered that statement. Were I to opine on the virtues of investing in the common stocks of small growing companies, who by the way are often fraught with risk, and you determined based upon my unbridled optimism for small cap stocks, to invest your entire retirement portfolio in the afore mentioned little growth engines that could. You quite possibly could find your self regretting your decision in only a few years time. As where, I quite possibly might find myself running down the middle of the street assailed by a hoard of disgruntled investors.

Were I to have the answer to the holy grail of the investment world, I would probably not be writing this article. What is the best way to invest your money for the long term? The answers we find in investment books, from stock market gurus, on web sites related to investing, from friends, relatives, and finally the guy at the corner store, are many and varied. I would venture to say that the real answer can be found inside each of us. To understand my supposition you must attempt to understand yourself. Thus, Ben Graham's quote.

"Past performance does not guarantee future results". I'm sure many investors have heard or read that little ditty at some time. Let's cut this phrase down to it's proper size, I prefer to read it this way, predicting the future is a fools folly, or simply the future is unknown. However, regarding investing one variable we can attempt to predict is our own behavior. The investment world is built upon supposition, one particular belief is that when we are young we can afford to invest in classes of investments that carry a high level of risk. The supposition is that if a young investor incurs losses at the hands of the market, he or she can make up those losses overtime because their investment horizon is longer. The beliefs and suppositions regarding investing are endless, your hard earned money is not.

Factors we control regarding our investment practices might include: our level of knowledge related to markets, economies, interest rates, analysis of companies, our behaviors in concert with market conditions, and our investment philosophies. To know ourselves in relationship to investing we must look at our own personal abilities in these areas. We must be honest with ourselves regarding the level of knowledge we posses, once we have done this we can begin to influence these factors that we exercise some control over.

This should not be an exercise in personal exploration that requires you to go to a stock market spa and resort. It's a simple acknowledgement of our level of knowledge regarding investing. If we acknowledge that we really do not understand most of what is involved with investing in stocks, mutual funds, exchange traded funds. Etc. That is fine, and acceptable. Armed with this acknowledgement we must then determine how we wish to proceed. We can either determine to hand over our investing activities to a trained professional, or to increase our level of knowledge regarding investing. Another possibility would be to utilize a financial professional with the majority of the funds you wish to invest initially , say 80% of our money set aside for investing, and to utilize a smaller portion in this case 20% of our funds, to use for our own investment activities. As you increase your level of proficiency you might increase the portion of money that you control. Over time you might decide that indeed you can do better than the so called professional.

Other variables that you must consider would include your age, your financial security, and ability to suffer losses while investing. You may determine that based upon your age and or your financial situation it is safer for you to utilize investment vehicles that carry very low risk, those that carry an intermediate level of risk, or those asset classes that carry the highest level of risk, or some combination of each risk level.

For the individual investor risk related to potential return on investment is a very important topic of concern and should be fully understood. Different asset classes carry varying levels of risk, it is therefore imperative for investors to understand these classes. The risk pyramid chronicles risk in asset types: the lowest risk in the bottom one-third, US Treasury Bills, US Treasury Bonds, CD's, Money Market Funds; the middle one-third contains Federal Agency Bonds, Conservative Bonds, Municipal Bonds, Balanced Mutual Funds, Index Funds, and Blue Chip Stocks; the top one-third contains International Bonds, Rental Income Properties, Growth Stocks, Foreign Stocks, Collectables, Junk Bonds, and New Ventures. Investment risk increases as you go up the pyramid! For more information related to this important topic see my article located on the web at: http://www.helium.com/tm/458369/great-military-philo sopher-advised

Knowing the best way to invest for the long term is far less important than understanding our own abilities and behaviors. It is through this process that we can begin to make our best guess at what the answer to that riddle might be. In my opinion there is no right answer to that question. Growth stocks, mutual funds, value stocks, bonds, index funds, small cap stocks, balanced mutual funds, life - cycle mutual funds, possibly a little of each, or higher exposure to one class of investment and less to another. Perhaps a better question to ask might be, knowing my abilities and limitations in regards to investing what would be the best way for ME to invest for the long term?