There are principles in Finance that are rigorously studied at the highest levels of Academia , which often come across as abstract, obtuse, and barely understandable. Frequently these principles boil down to some basic common sense such as:
- You should only take risk you have a reasonable chance of being compensated to take. Higher risk assets should offer higher expected returns.
- Take only as much rick as you can afford to take. Don’t bet the farm unless can afford to lose the farm.
- Don’t put all your eggs in one basket. Mitigate risk. Diversify. Diversify. Diversify.
All three of the above have one key word in common, ‘Risk.’ Anything you can do to mitigate risk while keeping the opportunity for the same return, or even higher return, you should absolutely jump on. Let’s dig into each one a bit further…
No. 1 Risk & Return
While hard for some people to grasp, holding concentrated equity holdings in just a few companies often backfires. You are just not compensated for the amount of risk each company faces individually since it is so easy to hold a broadly diversified basket of stocks. The simplest way to avoid getting one bum egg is to buy a couple dozen of them. Start with buying the Vanguard Total Stock Market ETF (Ticker VTI) and be done with it.
No. 2 How Much Risk Can You Handle?
Nearly all of us likely need to save more. The best strategy is to start as early as possible so that you have the most time to invest and handle any bumps in the road, which will always occur. The tough-love truth of it all is that as you get older and closer to retirement, time is running out and you need to start investing in more stable, lower return, investments.
In a very simple example, take the above fairly volatile higher expected return Vanguard Total Stock Market ETF (VTI), and pair it with the more stable, lower expected return iShares Core U.S Aggregate Bond ETF (AGG), increasing how much you invest in the more stable U.S. Aggregate Bond investment over time. Fine tune the mix to best fit you. Here’s a pretty generic example to give you the gist of it all-
Risk is a very personal thing. Here’s a link for a risk profile questionnaire from Vanguard that can help get you going: https://personal.vanguard.com/us/FundsInvQuestionnaire.
No. 3 The Risk Mitigating Mosaic – More. More. More. Plus…
Diversify. Diversify. Diversify. In the above example, I took two assets classes, U.S. Stocks and U.S. Bonds, and with your judicious pairing of just those two asset classes you have taken a big amount of risk out of your portfolio and you have fine-tuned your investments to fit your specific needs.
However, why stop there? Dig into it deeper and go from there. A good primer for those willing to dive in beyond the baby pool (probably a good idea) is William Bernstein’s The Intelligent Asset Allocator (http://a.co/bfriM8e). After reading that you may start seeing the artistry in such mosaics as this one –
Perhaps we can dive into deeper detail in future posts on the broad range of asset classes and how more value can be added by more diversification.