All this information about investing, stocks, index funds, and bonds is great but it can be a lot to handle. What should I really have in my portfolio and how much of each? Let’s dig into that a little bit now.
If you want to invest properly, your portfolio (this just means your list of investments) should be diversified. You’ve probably heard that before but what does that mean? Well, the more differentiated your investments are the better off you’re likely to be. I like to view differentiation in two ways. One way to differentiate is by the investment return source while the other is by investment type. Let me explain.
In order to have diversified sources, they primary return driver (what causes the investment to move up or down) should be unique and you need to cover a wide range of return drivers. To make this more concrete, let’s say you’re picking stocks (not a good idea, mind you). All stocks are the same in the sense that you’re buying a piece of a company and hoping they grow and provide a high rate of return. But, all stocks are different in the sense that no two companies are exactly the same. In order to diversify your stock selection and pick different return drivers, it would be wise to pick a company or two in all the available industries. A financial company’s returns come from a different source than a pharmaceutical company, right? And while there may be indicators that one industry may do well or not, it would be best to just have an interest in all of them. If you’re hunch in a particular industry was wrong and it tanks, your investments may get an unexpected boost from somewhere else. If you extend this idea further it would be better to just own all the companies in each industry, right? Well, that’s the idea behind index funds.
Now, there are also different types of investments. There are dozens, if not hundreds of them in fact. The simplest example would be stocks vs bonds. Those are two different types. A diversified portfolio is not going to have only one type of investment in it. Why? Because when something happens to a particular investment it generally affects all the other investments of the same type. If you have more than one investment type it helps to smooth out the ride. As mentioned there are many more types of investments (rental properties, options, angel investing, etc.) which can get quite complicated but I’d recommend focusing primarily on just stocks, bonds, and plain old cash unless you really know what you are doing.
So, how much should I put into each? Great question.
Let’s focus first on stocks and bonds. Stocks have historically crushed the returns of bonds, hands down. There is good reason for this, stocks take on more risk. The company could fail, the market could drop for some unknown reason, there could be a scandal, the list goes on. The only way bonds can completely fail is in the case of a default (meaning the debt holder can no longer make their payments). However, this is rare and if you check the ratings of the bond (AAA is the best rating given) anything with an A rating or better is extremely unlikely to fail (but of course it can happen, think of 2008). Bonds can lose value over time if you try to sell the bond before maturity and interest rates have risen. Think about it, if you have a bond paying 2% and 5 years later you could get a bond paying 5% which would you take? So the bond with the lower paying interest rate must be sold at a discount in order to sell at all. The opposite is true as well. If interest rates went from 5% to 2%, the price of the bond would rise. All of that does not matter however if you keep the bond until it has reached maturity, which I recommend doing.
So stocks pay more (think 10%) but bonds (think 3%) are more stable. Bonds can certainly outperform stocks and have in the past but this is not terribly common. Back in the 80’s, bonds were paying nearly 15%. The returns from bonds are driven largely by the national interest rate which is controlled by the Fed (the central US government bank). Right now, the national interest rate is around 1% which is why bonds are so unpopular at the moment. Typically, it is moved up or down based on the amount of inflation (or deflation) across the country. The more inflation there is the higher the national interest rate in an attempt to drive inflation lower, while the lower inflation is (or if there is deflation) the lower the rate. The goal for inflation is around 2% annually. If that’s not complicated enough for you, there is certainly more involved but those are some of the basics.
Back to the original question, how much of each? Since it would pay to figure that out (quite literally) there have been numerous studies done. Pretty consistently it is recommended to have roughly 75% in stocks and 20% or so in bonds. This is aggressive enough to provide high returns but also have enough in bonds to help smooth out the waves in the market. The last 5% remaining would be left for cash reserves. This simply helps to give you the ability to cover unexpected costs without having to dig into investments, and allows you to buy more if there is a dip in stocks or bonds, or whatever it may be. Are those percentages right for everyone? No. If you can’t stand seeing your investments lose money, go heavier on the bonds. If you simply want to make as much as you can and are able to watch your investments go up and down, put more into stocks. After all, the decision is up to you.