Let’s start investing. Let’s start building up assets. Let’s start going down the MoneySense road that leads to financial independence.
The MoneySense investor, the person who ultimately achieves a goal, has at least two important characteristics: this person has patience and a balanced investment approach. This means he or she is ready to commit to spending discipline and to investing on a regular basis, such as each pay period or once a month, over the long term. That means he or she will use different kinds of investments.
This is an approach that reduces risk. This sage investor doesn’t put all his or her investments in one stock or even just in stocks or does all his or her investing over a short period. Indeed, what happens if the investor dumps a bucketload of money into the market when it is about the make new highs and is now oversold?
No, the MoneySense investor has a diversified plan for today, tomorrow and ten years from now. He or she also has a mix of stocks and bonds as well as possibly a few other things. He may own his or her house or apartment in an expensive city, expecting to sell it at a profit and later move to a cheaper city. He or she may own a second apartment or home as an investment.
Many correctly argue the asset allocation decision is the most important driver in investment returns. Asset allocation means how you allocate your investments. What percentage will go to stocks, bonds, cash and real estate etc. The most common long-term asset allocation, for those with twenty years or more to invest, tends to be sixty percent stocks and forty percent bonds.
Ken Fisher, a long-time investment adviser and money manager, makes that argument. He writes that correct asset allocation is critical to any long-term investment plan. Having diverse investments in a plan is very important, he believes.
One can‘t get from Point A, someone with little or no assets, to Point Z, someone with substantial assets, enough to achieve financial independence, without a road map.
Why, an adviser such as Fisher asks, are you investing without a long-term plan? The MoneySense investor puts his money in more than one kind of investments. These are called asset classes. These investments include stocks, bonds, real estate and other things such as cash, such as money market accounts.
Buy on the Cheap
Some of the principles the MoneySense investor uses include: Buy low expense investments, preferably index funds, and be sure you mix your investments. The latter should include both stocks and bonds, but it should never be just stocks or just bonds. You should also have a bit of cash, which, in bad times, can be your best investment.
The reason for diversification is that no one can know with certainty if the next investment cycle will be bad for stocks or for bonds or any investment. Bonds and stocks tend to move in different directions. Stocks, long term, perform better than bonds.
So why not put all your money in stocks?
If you are an aggressive investor and if you are very young, with decades to recover from losses, an argument can be made for a stock only approach for a while. But most people don’t have limitless time to invest—I only seriously started in my late 30s—and many people don’t have the stomach to hang in for decades to get good returns. They often interrupt their efforts to spend on what often turn out to be superfluous things or they stop investing because they are facing a bad period. There is something else: In some periods, not all or most, bonds have beaten stocks. When? I’m not sure exactly when. But I know, that over almost any given 20-year period, it will happen sometime.
So the most important thing the investor should remember is don’t put all your eggs in one asset class basket. This way, when stocks are down, your bond investments will likely be doing well. In a diversified portfolio, the reverse will also happen—a bad time for bonds generally will mean stocks are doing well.
Diversification carries the investor through rocky times. It doesn’t guarantee that he or she will never lose money. Still, it is a very important factor in ensuring that one gets good returns over the long term. That’s even though we know that the long term also means some periods of lousy returns.
How?
Why?
We’ll answer these questions in the next installment.
