The Basics of a Diversified Portfolio
A diversified portfolio should be diversified in two respects: between asset classes and within asset classes. Therefore, in addition to allocating your assets among stocks, bonds, and cash equivalents, you need to mix your investments within each of these three asset classes. In this blog, we explain What is Diversified Portfolio with examples.
The key to doing this successfully is to identify investments that may perform differently under different market conditions. For example, you should locate a stock that does not go down (or does not go down much) in a declining or bear market.
The search for a stock that behaves in this manner, also known as correlation, is not easy; in essence, finding such stock is how portfolio managers earn their money. Investment textbooks available at public libraries can tell you how this can be done.
A word of advice, however: leave this to the pros! If you choose to go about trying to select lower positively correlated or negatively correlated stocks on your own, you will quickly expend a lot of research time and possibly money and probably still not pick the stocks correctly.
Because achieving effective diversification is not easy, you may prefer to purchase a number of mutual funds. Mutual funds are a type of professionally managed asset, regulated by an investment company, that pools money from many investors and invests in stocks, bonds, and financial assets.
Such a fund makes it easy for the individual investor to own a small portion of a great number of investments. Be careful: a mutual fund investment does not necessarily guarantee instant diversification.
For example, the mutual fund may be investing only in stocks issued by companies involved in the same industry (called a sector fund). Thus, if you purchase a sector mutual fund, you have diversified between asset classes but not within asset classes.
A mutual fund investing only in the stocks of technology companies is not participating in the broader market, which includes the stocks of many more types of companies and industries.
There are also ways to purchase mutual funds that are automatically diversified based on your age and life stage. A life-cycle fund is a diversified mutual fund that automatically shifts toward a more conservative mix of investments (more bonds, fewer stocks) as it approaches a particular year in the future, known as its target date.
The Basics of Rebalancing
Rebalancing is a fundamental aspect of the initial asset-allocation decision and is necessary to bring your portfolio back to its original asset mix or percentages. Why is this required?
Over time, some of your investments and asset classes will grow more quickly (or decline more) than other classes, thus deviating from the original percentages you specified as a part of your investment policy statement.
Let’s say the stock market had a “good year” (a year in which the asset values of the majority of stocks increased in price). As a result, your initial stock allocation of 60 percent has now increased to 75 percent of your total portfolio.
You are faced with either selling off some of your stock investments or purchasing more investments from the bonds and cash or cash equivalents asset classes, assuming that you wish to remain true to the asset allocation you established when the investment policy statement was prepared.
This is not a bad thing. Portfolio rebalancing is an automatic trigger that will assist you in the practical accomplishment of this step.
How often should you rebalance your portfolio? Like many other questions in financial planning and wealth building, this one has no definitive answer.
If you have engaged the services of an investment advisor or professional financial planner, and a separate account has been established to hold your assets, the advisor will notify you when it is time to rebalance.
Alternatively, if you are proceeding on your own, this decision is yours to make, although an annual rebalancing is likely prudent. Whatever the time frame, before you rebalance your portfolio, consider any transaction fees or income tax consequences that may result from the rebalancing.
If you have invested in a taxable account and experienced a loss on the value of your stocks or bonds, consider selling those assets now and using the loss against your income taxes. By doing so, you also avoid one of the biggest mistakes of the average investor: refusing to let go.
Some securities will never return to their original value. Even if they do, think of what you could have made with your money in the meantime. The opportunity cost of what you could have done with your money—but did not—is rarely considered by the average investor.
The Need for an Investment Policy Statement
Many planners refer to the investment policy statement as the third mandatory personal financial statement. The investment policy statement helps the investor specify realistic investment goals while also forcing them to consider the risks and costs of investing.
For example, specifying that you wish to obtain an average 15 percent annual rate of return on an investment in an individual stock begs the question of whether you also expect the stock to increase in price by this same amount consistently every year.
If so, you need to engage in a reality check! Such thinking ignores the risk of stock investing because the market price of stocks can fluctuate dramatically from year to year. This is known as volatility, which you need to understand and accept as a risk prior to investing in the stock market.
Any well-developed investment policy statement has four basic sections. With allowances for the specific wording of any customized statement, these sections are:
Statement of the Investor’s Objectives: The formulation and statement of these objectives are your primary input to the statement and should explain your investment goals in terms of investment risk and return.
A careful analysis of your risk tolerance should precede any discussion of return objectives. As we have discussed, typically, you will not know how to adequately define your risk tolerance; accordingly, this is one of the benefits of using a financial planner, who will help assess and clearly specify the amount of risk you are willing to assume.
A person’s return objectives may be stated in terms of a percentage, but they may also be stated in words. For example, capital preservation means investors seek to maintain the purchasing power of their investment—therefore, the necessary return must be no less than the rate of annual inflation.
Alternatively, capital appreciation is an appropriate objective when the investor wants to achieve growth of their investment through capital gains (a return considerably more than annual inflation). A current income objective means the investor wants the manager to invest in dividend-paying stocks or interest-earning bonds to generate income.
Finally, a total return strategy implies that the investor seeks to increase the value of investments by taking advantage of both capital gains and reinvesting any current income back into the investment for future growth of principal.
Statement of Investment Constraints or Limitations: In this section of the statement, you need to specify your investment time horizon or the time period in which you intend to invest.
Concomitant to this time period is your need to access the money without a significant loss to the principal (also known as liquidity).
Investors with longer investment horizons, such as an investor who is saving for retirement, generally require less liquidity and can thus tolerate more investment risk.
Investors with shorter time horizons, such as an investor already in retirement, generally seek greater liquidity and less risky investments because losses cannot be overcome nearly as quickly.
Additional factors or limitations that you will typically wish to consider when developing a policy statement are the current and expected state of the overall economy and sectors of the economy in which you may be considering investing (for example, technology). The current tax status of any previous investments should also be taken into account.
For example, an individual who is saving for retirement and is taking advantage of the tax-deferred nature of an individual retirement account (IRA) may engage in more frequent investment transactions than someone who holds these investments in a taxable portfolio where capital gains must be recognized at the date of sale.
A final, often-included limitation covers the unique circumstances or preferences of the investor. Here is where you should state any preference to invest only in socially responsible companies. Similarly, you should give some thought to your current or anticipated cash flow.
For example, if one of your goals is to purchase a vacation home during a shorter, specified time period, you will need to invest in relatively liquid assets. Alternatively, if you expect to receive a large inheritance during the time period (thus providing additional money for investment), you should discuss what you want to do with this money.
Meeting the Investor’s Objectives and Allocation of Investment Resources: Although the typical investment policy statement does not indicate specific stocks or bonds the investor should purchase or sell, it should provide guidelines with respect to which asset classes to include and the relative percentages of each.
In other words, the investment policy statement should provide an asset allocation strategy.
The assets you may wish to invest in may not be the same as the typical investor based on your risk-tolerance level, desired rate of return, and investment time horizon. However, most investment policy statements use only three categories or classes of investment assets:
Cash or cash equivalents (savings accounts, short-term certificates of deposit, money market funds, and an asset that is relatively liquid)
Investment percentages are assigned to each class. (Note: Sometimes a fourth category, referred to as alternative investments, is also used as an asset class. These are any assets other than stocks, bonds, and cash, such as gold or silver.)
Many methods are used to allocate the investment percentages, including some involving computer software. There are also a few rules of thumb. For example, one commonly cited rule is that you should subtract your age from 100 to determine the percentage amount that should be devoted to stock or stock mutual fund investments.
The rest should be split between bonds and cash or cash equivalents, with only a relatively small percentage allocated to cash given its lack of relative return. Here are four sample asset-allocation scenarios for a young, mid-life, pre-retiree, and retired investor of moderate risk tolerance:
Young investor (aged 25 to 44): 75 percent stocks; 20 percent bonds; 5 percent cash or cash equivalents
Mid-life investor (aged 45 to 55): 60 percent stocks; 30 percent bonds; 10 percent cash or cash equivalents
Pre-retiree investor (aged 55 to 64): 50 percent stocks; 35 percent bonds; 15 percent cash or cash equivalents
Retired investor (age 65 plus): 40 percent stocks; 40 percent bonds; 20 percent cash or cash equivalents
Once the asset-allocation process has been determined, you should consider a mix of assets that have the highest probability of meeting your financial goals at a level of risk with which you are comfortable. As you get closer to meeting your financial goal, you should adjust this asset mix.
For example, if you are several years away from meeting your goal, the safety of principal should become more important to you than the growth of that principle; accordingly, you should adjust the percentage of asset mix toward short-term bonds and cash equivalents and away from stocks.
Asset allocation generates portfolio diversification, which is the key to reducing your investment risk. We will talk more about diversification later in this blog, but for now, you should understand that a well-thought-out asset-allocation strategy is the foundation of any effective investment policy statement.
Monitoring the Performance of the Investment Plan: The drafting of a policy statement will assist you in judging the performance of your investment manager. Typically, the statement should include a model or benchmark portfolio against which the performance of the manager may be judged.
For example, if you choose to invest in large-capitalization stocks (companies that have a large amount of outstanding public stock), you will likely want to compare the performance of the manager against the benchmark annual return of Standard & Poor’s Index of 500 stocks.
Alternatively, if you choose to invest in smaller-capitalization stocks, a benchmark portfolio of similar stocks, such as the Russell 2000 Index, should be used.
Because benchmark portfolios set an objective performance standard, the investment policy statement acts as a starting point for periodic portfolio review and assessment of investment manager performance.
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Buy and Hold
Another phrase that describes the buy-and-hold investment strategy is passive portfolio management. In other words, the investor does not intend to actively trade the stocks, bonds, or other assets in their portfolio and instead chooses to own those investments for a relatively long time.
Buy and hold, coupled with dollar-cost averaging, is a common strategy for building wealth to meet the average investor’s saving-for-retirement financial planning goal.
The buy-and-hold strategy has several advantages:
You can minimize your acquisition and trading costs in the trading of securities, leading to considerable savings over time.
It will assist you in managing your income tax obligations. For example, if you do not sell a security in a given year, you do not need to recognize a capital gain or loss on your income tax return.
Academic studies have shown that the most significant gains in the securities markets are made during several trading days throughout the year; a buy-and-hold strategy ensures that you will not be out of the market during those days.
A warning: many individuals say they are buy-and-hold investors when, in fact, they are not. Most of us allow changing market conditions to influence our buy-and-sell trading decisions. In other words, we let short-term emotions get in the way of our long-term investment decisions.
Mega-investor Warren Buffett has made his investors rich in part by not permitting emotions to dictate his investment philosophy. If you are a pure-buy-and-hold investor, you will remain in the market for a long time with little concern for market volatility.
Market timing is the behavioral opposite of the buy-and-hold strategy. It is an attempt to predict the overall direction of the securities market and to take advantage of the market’s volatility, whether that general direction is up (a bull market) or down (a bear market).
Market timing should not be confused with the rebalancing strategy discussed earlier in this blog. You should rebalance your portfolio to maintain consistent asset-allocation percentages over time.
However, when you rebalance, you are responding to rules and conditions that you have established: through an asset-allocation strategy, included in an investment policy statement, that is intended to culminate in the meeting of your financial goals.
Market timing responds to external market circumstances—rules and conditions that have been established by the market—over which you have no control. In actual practice, portfolio rebalancing is proactive, whereas market timing is reactive.
Does market timing work? Probably not, largely for the reason mentioned earlier—an investor needs to stay invested in the market all year long to experience the greatest gains. Nevertheless, if done properly, market timing can have some value.
For example, as an investor, you should pay attention to reports that indicate whether a large number of market timers are either buying or selling over a period of several weeks. This may give you some perspective with respect to overall market sentiment (and, accordingly, whether the market is likely to go up or down).
In the financial world, correlation measures the direction and extent of a relationship between two investment assets. However, you can also use this concept to diversify your portfolio and accumulate wealth.
How does correlation work? A correlation of +1.0 means two assets move exactly together in one direction, whereas a correlation of -1.0 means the two assets move in the exact opposite direction of each other—that is, when one goes up, the other goes down.
Meanwhile, a correlation of 0.0 means there is no relationship whatsoever between the two assets—that is, they move independently of each other.
Financial or Real Assets: Which Are Better?
A great amount of wealth has been created (the accumulation part of the PADD process) by individuals investing in financial and real assets. Nevertheless, this process is not a zero-sum game. The wealth-accumulation techniques involved with each type of asset are not mutually exclusive.
Many investors prefer to invest in either financial assets or real assets, but not both. The general reason is that those investors are investing in assets they understand (or someone has convinced them they understand), or they are comfortable with only one of the two general categories of assets.
If you understand your ability to assume differing amounts of risk, however, you may wish to invest in both financial and real assets. History has shown that adding real assets to a predominantly financial portfolio improves diversification and reduces overall risk.
Remember: the goal of wealth accumulation is not only to achieve as great an annual percentage of return as possible but also to do so with as little risk as possible.
As such, you might consider investing in real-estate investments that look more like financial investments (for example, a REIT is a mutual fund that invests in real estate and real-estate properties). Alternatively, you can invest in securities issued by real-estate development companies and home builders.
Regardless of whether you decide to invest solely in financial assets, solely in real assets, or in both, do not forget this fundamental rule of investing: if you do not understand a potential investment, you should not be investing your hard-earned money in it!
Prior to the most recent recession that began in December 2007, some investors ignored this basic rule and piled money into exotic derivative investments, such as credit-default swaps, whose underlying risk they did not appreciate and whose complexities they did not understand.
Now let’s move on to a topic of great interest to investors and non-investors alike: how to buy a home and take the best advantage of use assets in accumulating wealth.
The effective management of use assets is the focus of the next blog and concludes our look at the second step in the PADD process: techniques to accumulate wealth. After that, we take up the defense of that hard-earned wealth using effective tax management.
Indirect Investments in Real Estate
There are two basic ways to indirectly invest in real estate: as a limited partner owning an interest in a RELP or as a shareholder in a REIT. Let’s look at the REIT first, because it is generally the more marketable of the two investments.
Real Estate Investment Trusts (REITs)
A REIT is like a mutual fund, except that its shares are not always valued at net asset value (NAV). Instead, they are traded at a premium or discount to NAV on a publicly traded exchange.
In most cases, the REIT invests in income-producing real-estate properties, such as apartment buildings, shopping centers, office parks, hotels, and, increasingly, retirement communities. Some REITs, known as mortgage REITs, also invest in the financing of real estate properties.
The REIT entity is not subject to federal income tax as long as it distributes at least 90 percent of its annual income to shareholders each year. As a result, many REITs distribute 100 percent of their annual income to shareholders. Taxes are then paid by the shareholders on dividends received (like stocks or stock mutual funds) and any passed-through capital gains, but be careful:
unless the REIT tells you the dividend is a qualifying dividend for federal income tax purposes, you cannot claim the favorable 0 or 20 percent tax rate that otherwise applies to stock or mutual-fund dividends. Further, unlike RELPs, REITs cannot pass through any losses experienced in the sale of their underlying properties.
There is a relatively low correlation between the price movement of REIT shares and that of a typical stock or stock mutual fund. A primary advantage to you, as a potential investor, then, is the opportunity to further diversify your portfolio with the purchase of a REIT. Other advantages of REITs include
Relatively stable dividend income
High dividend yields
The possibility of significant capital appreciation
Access to professional management of the property
The long-term total return (defined as dividend income plus a capital appreciation of the underlying real-estate investment) of a REIT is likely less than a high-performing, higher-risk growth stock, but more than the return of a lower-risk investment-grade bond.
Before you invest in a REIT versus, for example, a mutual fund, you must first decide that you want to invest in real-estate properties. Then you must decide in what manner you wish to invest in those properties—directly or indirectly.
If you decide that you want to invest indirectly in the form of a REIT, you must decide whether you wish to invest in a publicly traded or non-publicly traded REIT. Finally, in what type of REIT should you invest? There are three types:
Equity REIT: Generally acquires income-producing real properties
Mortgage REIT: Makes construction loans and otherwise invests in the financing of real-estate ventures
Hybrid REIT: Both owns properties and makes financing loans
As a general rule, a mortgage REIT is a bit riskier than an equity REIT, because the mortgage REIT does not have established properties from which to generate an income stream to the investor. However, your ultimate rate of return from a mortgage REIT may be greater than from an equity REIT.
Real Estate Limited Partnerships (RELPs)
If you want a high-risk real-estate investment and the possibility of a high return, purchasing an interest in a RELP may be for you. A RELP is most commonly structured as real-estate syndication with one or more general partners or real-estate developers and many investors as limited partners.
The limited partners have no say in the management or control of the real property investments or in when the underlying properties may be sold.
Unlike a REIT, a RELP is permitted to pass on losses to its limited partner investors. However, because of a series of income-tax rules known as the passive activity rules, it is doubtful that you, as a limited partner investor, can claim this loss on your annual income tax return.
Typically, you cannot claim this loss until the general partner or syndicator sells the partnership property that has generated the loss—and remember, as a limited partner, you cannot legally force them to do so.
A RELP usually is not a publicly traded entity, so cashing in your interest at something close to what you paid for it is difficult, if not impossible.
Some RELPs are organized and publicly traded in the form of master limited partnerships (MLPs), but the trading is very thin, and tax rules generally restrict the claiming of any losses on your income tax return. Thus, an interest held in a RELP is generally both illiquid and relatively unmarketable.
So why invest in a RELP? You would do so almost always because you believe in the ability of the syndicator to develop and sell the underlying real properties for a significant profit.
In addition, you are able to invest in commercial and residential real estate properties for a relatively small amount and are limited in your potential liability as a creditor only to the extent of your investment.
The Use of Leverage in Real-Estate Investing
The financial concept of leverage is the use of borrowed money to increase your profit on a real-estate investment.
The concept may also be used with financial assets, most notably through the use of margin (borrowing money from your broker to purchase stock), but one of the oft-cited advantages of real assets is the ability to employ leverage effectively.
For example, assume that you have directly invested $100,000 in residential real estate property. Further, assume that this real estate is in a good location and appreciates at a rate of 10 percent annually.
At the end of year one, your investment has grown to $110,000, and at the end of year two, the property is worth $121,000. You have earned a $21,000 profit in the property.
Now let’s assume that you have put down $100,000 on a $500,000 tract of residential real property and have borrowed the remaining $400,000 from a bank at a low-interest rate.
Again, the property appreciates at the rate of 10 percent annually. Now, however, at the end of year one, your investment has grown to $550,000, and at the end of year two, the property is worth $605,000.
Thus you have increased your dollar profit from $21,000 to $84,000 ($105,000 less $21,000). That is four times your original profit, or a total percentage return of 400 percent before figuring in dollars and percentage rate you have to pay to the bank for borrowing the money.
How do you put the concept of leveraging into practice as a real-estate investor? You do this by putting the minimum down on real property that has a strong likelihood of appreciating in future years. Generally, on any real-estate purchase other than primary home purchases, the bank will ask you to put down at least 20 percent on the initial investment.
If you can find a bank that will let you put down less, and you are relatively sure that the property you are interested in will go up in value, you should be able to understand the benefits of using someone else’s money to accumulate wealth. That is leverage!
However, be aware that leveraging also compounds your dollar loss if the property goes down in value. Using the previous two examples, if leverage is not used, you end up with a $19,000 loss after two years.
Because you are dealing with residential rental property, you may or may not be able to claim all of that loss on your tax return, depending on your AGI at the end of year two.
If you used leverage, on the other hand, your loss is $95,000, a difference of $76,000 ($95,000 less $19,000). Regardless of your AGI, you definitely cannot take all of that loss for income-tax purposes, because you are limited to no more than $25,000 in any given year. In addition, you still have to pay the bank for any interest incurred on the loan during the two years.