Guidelines for Investing at Record Market Highs - Part IISubmitted by Reed Financial Group on January 22nd, 2020
A final word about exuberant markets and diversification from Doug Reed.
Diversify Your Investments
Once you know what your goals financial goals are, and your tolerance for risk, it’s time to build a portfolio.
A key component to risk management is diversification.
By owning companies (stocks) you may be able to properly diversify your portfolio with as little as 5 to 10 companies. Depending on your goals and how much you plan to delve into the portfolio, you may want to further diversify your portfolio to 20 to 50 companies. These companies should be in several different industries and various types. The companies could be large cap; more than 10 billion, mid cap; 5 to 10 billion or small cap; generally 2 to 5 billion in size. Micro cap are less than 2 billion and may create more volatility than you need in order to reach your goals
Know what you own. This is key to proper stock (or any asset) ownership. As Peter Lynch points out in his book, Beating the Street, many wonderful investments are household names. Companies like Walmart, Amazon, Hershey, Coke and many others have provided solid opportunities.
Bonds. Owning bonds in your portfolio may help to create income and some risk reduction management. A bond is sort of like a loan from you to the organization which issues the bond. Bonds come in many maturities and investment grades and understanding what you own is important.
Other ways to diversify may be by owing real estate or REIT’s. A REIT is similar to a stock in that it can be traded over an exchange or it could be private an not traded. It could be similar to a mutual fund or ETF in that they may hold many properties. However the legal structure is different. The real estate may be apartments, shopping centers, industrial, warehouses or many other types of real estate related investments. They could also be loans for these types of properties.
The key to diversification is to know what you own and to know if it is making money (proven) or not making money, but expected to (speculative). Of course you want to avoid anything that is not making money and is not expected to. Duh, but sometimes this is hard to know, especially if you are speculating.
In order to diversify using stocks (companies), bonds or real estate, you must be willing to put in some time to learn what you should know. Buying anything on a “tip” from a well meaning but really not well knowing friend is a losers game.
Not only must you know what to buy and what you own, you may also have to know when it’s a good time to let the investment go away.
Use Mutual Funds and/or ETFs
These are diversified buckets of holdings that follow general market rises and falls. The odds of one or a few companies dropping to zero at the same time are slim. The odds of all the companies going to zero at the same time in a mutual fund are almost nonexistent.
Investing in more than one fund is also a basic part of protecting your portfolio with diversification and asset allocation (two different tactics).
Diversification is the practice of holding more than one security. Most mutual funds and ETF’s hold 20, 50 even 100 or more companies within the fund thereby creating instant diversification. Some funds that invest in indexes like the Nasdaq or Russell 2000 have more than 1000 companies. If you've read about diversification above, you probably realize, it’s too many.
Asset allocation is the practice of spreading your holdings among various classes of holdings. These holdings may be large U.S. companies, small U.S. companies, Foreign companies, Bonds of U.S. or International companies as well as bonds of various governments
Beware of the mistake of over diversification or mismanaging fund holdings. For instance, holding too many mutual funds in every asset class available will probably water down returns as well as the “protection” asset allocation is supposed to provide. Further, holding several funds investing in the same thing is not diversification or asset allocation. Generally, a well allocated and diversified portfolio does not need more than 5 to 10 well chosen, properly allocated funds. More than 10 funds is diversification, generally based on ignorance and more often than not a mistake.
Make a Plan
Forget about predicting the future. Correctly guessing one event is lucky. Nailing 10 events – that’s prediction or worse, guessing. Nobody accomplishes that regarding the markets all the time.
Approach investing without guessing or being guided by emotions. Emotional investing is often the worst type of investing.
• Develop a prudent plan. Include structured processes with decision rules to guide you and that already consider markets always going up and down. The degree of ups and downs you weather depends largely on your tolerance and capacity for risk.
• Customize your portfolio. Base it on the principles above and tailor it to you and your situation. Don’t invest based on chit-chat around the water cooler, structuring financial moves based on someone else’s situation and needs. To do so sends you chasing investments that are merely hot and not necessarily what’s prudent for you.
Combining and using these principles can provide you some comfort during any market.