RISK IS A BIG, BAD WORD for many people, particularly when it comes to investment. But risk you must, for without risk most will not meet The Happy Number retirement goal. Savings accounts will not get you there, so into the market you go (once you’ve done your financial planning, of course, including considerations such as savings for a home, your children’s college, emergency funds, etc!).
This may scare you, but as investor Robert Arnott once famously said, “In investing, what is comfortable is rarely profitable.” That’s why previous chapters discussed financial sensitivities a bit more than most investment books. If you’ve not read Parts One and Two, go back and do it now! It’s important.
Why?
To invest comfortably, you need to know where your risk-return zone is. Knowing this will help your feelings about financial risk guide, and not impede, investment decision making best for you.
If your risk tolerance is too low to invest in the securities needed to meet your Happy Number, then you are going to have to figure ways to step out of your comfort zone. Conversely, if you have no nose for smelling out risk, or don’t care about it, then you may be taking on more risk than you need.
Each investment type has an element of risk, some parts of which are definable, other not so much. This is true of the three types of investments most investors consider.
The first is equities. Equites are stocks, or any other security representing an ownership interest in a company.
Common stocks are the most common type of equity. They are shares of a company, each of which is worth the total market value of all company shares divided by the total number of shares of the company outstanding. A single share in a company with a total market value of $200 is worth $2, 10 shares $20. Common stocks are securities that represents ownership in a corporation. Those owning common stock have the right to vote on the election of a company’s board of directors and corporate policy. If a company is liquidated (chopped up and sold), its common shareholders get paid for their shares after bondholders, preferred shareholders, and other debtholders. A preferred stock is like a common stock but has a different form of ownership, namely, a higher claim on assets and earnings. It also usually has dividends that are paid before those of common stock shareholders (but usually without voting rights). In this way, preferred stock has both debt and common shares features.
Common and Preferred Stocks
A common stock is a security that represents ownership in a corporation. Holders of common stocks exercise control by electing a board of directors and voting on corporate policy. In the event of company liquidation, common shareholders have rights to a company’s assets only after bondholders, preferred shareholders, and other debtholders are paid in full.
A preferred stock is a class of ownership in a corporation that has a higher claim on assets and earnings than common stock. Preferred shares generally have a dividend that must be paid out before dividends to common shareholders, but the shares usually do not carry voting rights.
Preferred stock combines features of debt, in that it pays fixed dividends, and equity and has the potential to appreciate in price. The details of each preferred stock vary.
Source: investopedia.com
Equity investing refers to the buying, holding, and selling of company stocks. Most stocks are listed on a regulated stock market. Returns from shares come as capital gains (i.e., share prices rise as a company’s overall market value rises) and dividends, cash, or stock that a company determines to distribute to its shareholders (usually quarterly). Common share ownership gives you a vote at company annual meetings, or, as noted in Chapter Three, you can give your vote to a third party, such as a financial adviser or the managers of a fund that you invest in.
Equities come in all shapes and sizes. For now, it’s important to know only the basics. There are common shares and preferred shares (explained in box). There are large, mid, and small “cap” stocks. These refer to the total market capitalization of the company (the price per share multiplied by the number of shares available for purchase; this is explained further in the next section). Investors also refer to value or growth stocks. Value stocks are judged to be trading at a price-to-earnings ratio below average and are deemed to be undervalued because their prospects for growth are not reflected in the stock valuation. Growth stocks trade above the average price-to-earnings ratio because they are deemed to have greater prospects for growth. Put another way, their earnings growth is relatively high.
The second most common investments are corporate and government bonds. These are debt securities issued by companies or governments and sold to investors. A company’s ability to generate income to repay bonds (interest and principle) is the only guarantee an investor gets with this type of security. This guarantee is more than you get on most equities, but you don’t get any ownership rights. In the event of corporate difficulties, bond holders get paid first.
A Word or Two about Stock Selection
Sad to say, even most professionals don’t do stock selection well. Sometimes they win; sometimes they don’t. In fact, their stock selections often underperform those of chimpanzees. What?
You might not remember Burton Malkiel’s book A Random Walk Down Wall Street, but you may recall his theory that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” The Wall Street Journal took up the challenge and found that professional stock pickers did only slightly better than random darts thrown at pages of the Journal, and only a hair better than the Dow Jones Industrial Average.
Knowing this you may feel inclined to get your darts out of the case and roll with the chimps. Or maybe (better) not. Either way, stock selection is not a stroll through the zoo.
Like equities, investors can buy and sell bonds. This causes the value of the bonds to fluctuate as market and issuer conditions change. Because bonds have an interest payout that is known in advance, they are typically less risky than equities. Less risk means they also tend to have lower returns. Be careful to note bond ratings, from really good triple A to junk level. Need more of a definition?
Putting more into short-term bonds is less risky as interest rates can rise, but you get paid less interest in return. Long-term bonds have higher interest rates for the same company; however, they require tying up your capital longer, which implies interest rate risk. Who knows where rates will go? Many portfolios hold both short- and long-term bonds as a result: short for buying opportunities if rates rise and long to capture higher returns.
Cash and equivalents are the third type of investment. Cash is that stuff you keep under your mattress, in a coffee can on top of the fridge, in your savings account, or in your money market fund.
Cash equivalents include any other short-term investments that you can cash out quickly, say within three months. This would include U.S. treasury bills and short-term certificates of deposits. The key thing to know about cash is that it is liquid — available on short notice to buy things with! Cash should not be confused with credit cards that many seem to work like cash but alas must be repaid, usually on short notice; hence the coffee can over the fridge.
Cash equivalent investments are good short-term parking lots, but not great investments. Bank accounts are the worst. Incredibly, savings accounts and money market funds hold 30% of all individual investors’ funds in the United States: bad, bad, bad! History tells us you will lose about 1.7% a year on your cash as inflation chips away at it!46 So unless there is a good reason for holding cash like this, don’t do it.
Each type of investment has a generalizable risk level and return potential, and each tends to behave differently over time as economic and market conditions change.47 Rule of thumb: Equities have more risk, bonds less, and cash the least. For return potential, the inverse is normally true; equities have the best return potential, followed by bonds, then cash. I say normally, because the value of any type of investment will vary depending on when you sell it (or in the case of cash, spend it).
Since the early 1950s, the Standard and Poor 500 of large company equities average inflation adjusted return was just over 7.0%. The Barclays U.S. Aggregate Bond Index, which measures the performance of U.S. investment grade bonds (e.g., U.S Treasuries, government bond issues, corporate bonds), has averaged around 8.4% since 1980.48
Of course, any company stock can go bust, and they do go bust from time to time; even some of the so-called value stocks. Remember the great market meltdown of 2008–09. I do. I vividly remember the moment I figured things were really going south fast. It was March 2008. I was in a traffic jam in Mumbai, India, with plenty of time to read the innumerable billboards alongside the highway. On one I saw a picture of a gleaming, oversized New York blue glass skyscraper apartment building with improbable hanging gardens on random floors. Beautiful. The advert was for an investment fund with a “guaranteed return of 20%.” Later we came to know this was one of those infamous almost-took-the-global-economy-down, collateralized-debt-obligations funds full of rotten residential mortgages. That very moment, sweating in a Mumbai taxi, I knew the market was screwed. Within two weeks I was 90% cash. Talk about timing, right?!
Not so fast, it’s A Happy Story only so far. It gets sad, sadly. For in the crush of work, life, and fear of the unknown, I did not reinvest our cash until 2012. This cost me a loss of about 4% and an opportunity cost of about 28%. Market timing, it turns out, is as much about understanding the market as it is understanding your capacity to make investment decisions. To this day, I am unsure which is the bigger challenge of the two.
One moral we can find in this story is that if you buy and hold quality stocks, the risk that you are taking on is often more related to market movements than the performance of the company. This makes holding onto stocks through all the market crazy a better means to decent returns. Understanding risk in the market is challenging to say the least. Trying to predict the future of a given stock … well, many think this is just a fool’s gambit.
Buying the right mix of investments is a way to avoid having to guess at future market conditions and the performance of a given security. Investors use many strategies to get the mix right. Among the most common, successful, and simple to use, in my judgment, is asset allocation.
Asset allocation is a serious subject. It is so serious, if you Google “Asset Allocation Humor” you get a big Zero. Nada; rien; nichts. It’s either that serious or investment folk have no humor. (If you ask Google for investment humor, on the other hand, you get some gems, including this one, from investment professional Charlie Munger: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”)
So, what is this humorless thing, asset allocation?
According to Investopedia, asset allocation is an investment practice that balances risk and reward by dividing your portfolio according to your investment goals, risk tolerance, and investment horizon or how much you want to make, how afraid or unafraid you are of the market, and how long it will be before you need the money you are investing. Asset allocation in practice means how much equity, bonds, or cash as a percentage of your total capital you hold in your portfolio.
As you know, there are many classes of stocks and bonds, and the performance of each varies consistently under specific economic and market conditions. Some tend to go up in one type of market, while others tend to go down. Growth economies are good for equities, those of smaller companies in particular. Bonds are often better in sluggish economies, when equities’ value growth can stall, even contract.
This means each security has different risks. But conversely, each also provides a means to portfolio diversification that can round off the ups and downs of your portfolio as a whole.
Asset allocation strategies can be quite complex and employ all sorts of securities. Or they can be simple. In ILYGAD I use only the very basic allocation categories of cash, fixed income (i.e., bonds), and equities, which I also divide into three risk classes: low, average, and high.
Assessing equity risk can be complicated. Such assessments include individual stocks of many types and shapes and can include equity funds, each with different risk and return profiles.
Company size is one measure of risk, typically defined by market capitalization or the company sale value of outstanding shares. Micro companies have less than $300 million in value, small less than $2 billion, medium $10 billion, large $100 billion, and mega more than $100 billion. Larger and more established companies tend to have less risk, while smaller ones normally have better growth potential but higher risk. Value stocks are generally in well-established companies and usually have lower risk ratings. These are all just general risk classifications, and again, there is no guaranteed way to assess corporate risk.
Geography can also be used in allocations for both equities and bonds. Common categories include U.S. domestic, global, international, emerging markets, regional, frontier, etc. Developing country markets are normally higher risk, but again, the highest potential return as well.
These are the basic terms and asset classes. Other professionals use other terms, so it can be confusing. While conventional asset allocation guides are generally applicable, the allocation you decide on must be right for you. It must fit your goals, risk outlook, and investment horizon: There is no magic formula for the critical allocation jigsaw. Because I can provide only the minimum here, I urge you to read up on asset allocation.
Financial asset allocation done to your satisfaction and standards can reduce volatility in your portfolio through diversification. Choosing the right assets allows you to dilute risk across asset types, which can improve your portfolio’s earning potential. The right allocation can also avoid constant tending of your portfolio to meet the vagaries of the market.
The general rule of asset allocation is that you take more risk when you are young, then get more conservative as you get older. When you are young, time is on your side, so you can also ride out market downturns looking for those juicy long-term average returns.
As we age, we usually have (1) more wealth to protect, (2) less time to recoup severe losses, (3) greater need for income, and (4) perhaps an increased nervousness as markets jump around.
— John Bogle, Founder of the Vanguard Group
As you get older, less risk is conventionally called for. This means lower-risk and value stocks, especially those paying good dividends. The figure below shows a fairly conventional asset allocation by levels of risk tolerance, which also roughly corresponds to typical age-based allocations.
Note: When you think about your own portfolio, remember to figure in other non-market assets of value in your asset allocation calculation, including your home, other real estate, antiques, art, boats, jewelry, etc.
If you are risk averse or older, income-generating, high-quality bonds should take a larger share of your portfolio. They are less risky and can provide good income. Wisdom also has it that as you age you should give up on most equity risk, for more constant and steady income streams. This guideline is changing a bit but still conventionally applies.
What does asset allocation look like in practice? Take my example. I am fifty-four, have three teenagers, and don’t see myself fully retiring until around seventy. My portfolio is aggressive for my age with 70% equities, 20% bonds, and 10% cash. I don’t have a company pension and am in line for only basic Social Security, so I want to be a bit more aggressive.
On the other hand, we have some real estate investments that are not particularly risky. This allows me to be a bit more edgy with equity. When I include real estate in my portfolio, my equities drop to around 20% of our overall asset base, so my portfolio stance as a percentage of my household balance sheet is not particularly aggressive.
A commonly held rule of thumb is that the proportion of bonds in your holdings should be around the same as your age, although it could be less if you plan to work a bit longer than the typical retirement age, as I do. This guide works well for average mid- to late-Gen Xers if most equities are dividend-paying large cap companies.
For Millennials under thirty-five, you should hold mostly equities with various levels of risk suiting your risk-return appetite. Some suggest a balance of 20% large cap with lower risk and return potential, and 15% to 25% mid to small capital companies with more risk and potential growth. You should keep some cash in your portfolio for quick access, particularly for investment-buying opportunities and/or non-security asset purchases.
Both Gen Xers and Millennials should consider geographic diversification. Some international equity and income exposure can provide risk coverage, as not all regional markets move to the same rhythms. A stake in emerging markets might be good for the long term, but only if you have the stomach for it, and only well-known securities!
Cross-industrial sector diversification is also important, as not all sectors respond to market and economic conditions equally. Basic consumer goods and health care companies often do better in slower economies, while technology is often better in a rising economy.
Poor sector diversification can cause problems. Once I got carried away buying two rail stocks (I hate truck transport emissions) when I needed only one. Shortly after buying: POW! transportation tanked like a 1960s bad guy being hit by Batman — Millennials, don’t even try to understand this one — leaving me to wonder why I didn’t buy Costco or some other stock rather then two stocks in the same sector.
If I have misled you into thinking that there are absolute asset allocations by age, forgive me. There aren’t. The guidelines noted above are only intended to give you a sense of what conventional investment allocation looks like for younger and older investors.
Well done, asset allocation is important as you age and your investment context changes. Good allocation is also good for the mental health of Millennials, as “setting and forgetting” can tame some of your market-induced crazy. It’s good for Gen Xers health too, as winding down equity risk in favor of income securities keeps our hearts beating at a decent rhythm.
In Appendix Three you can find a list of asset allocation calculators. One I like is on the Smart Asset website.49 CNN Money has another simple-to-use allocator.50
You absolutely must remember to rebalance your allocations as your holdings gain and lose value and upset your desired allocation.
Think of tires on a car. Every now and then they need rebalancing. So too will your portfolio as the market inevitably pushes some investments up in value, and others down.
Your portfolio will also need realigning to remain in sync with your evolving risk tolerance, income position, and future needs. That’s the polite way of saying as you get older. When you are in your thirties and forties you can check alignment every three to five years, or after a major stock market event. Over fifty? Like that full physical you promised your significant other you’d do: Every year.
Rebalancing can require selling a portion of your investments, sometimes a scary portion, even if they have been good performers for you. Say your Google and Facebook stocks went up 100%; terrific, right?! Yes, but then these two stocks might dramatically increase the proportion of average risk equities in your portfolio. A rebalancing could be in order to keep your overall portfolio age-risk-investment allocation plan in place. You may want to sell some of Google and buy other asset types, or sell both and buy several new equities or bonds, depending on why you are rebalancing.
If this sounds like too much work or you are not going to trade on your own, you can also find packaged funds, or combinations of funds, that fit your asset-allocation needs. Not surprisingly, some of these funds are even called asset allocation funds! Others are called balanced funds. These funds hold more or less fixed proportions of asset classes — equity, income, and cash — in allocations meant to attract investors with particular risk and return profiles.
Critics of some of these types of funds argue that standard allocation solutions can never fit an individual investor’s needs.
I agree and disagree.
I agree because all investors have unique profiles and needs. But I disagree because of convenience. Few investors are interested in or have the capacity to invest in funds and/or securities on their own. In the end, it may be better to have good, relatively inexpensive, if imperfect allocation than none at all. For example, I don’t like to research bonds and bond funds. Don’t know why, but I don’t. I am an equity guy, I guess. So instead of fingernail-pulling research, I simply assessed and bought the best, heavy into-bond funds I could find. Simple easy, and I got a whole portfolio of corporate bonds working for me in one afternoon!
This brings us to market timing. This paragraph will be a short. Rule of thumb: Don’t do it. Timing the market is just too hard.
Some investment professionals have explicit market-timing strategies. That is, they try to buy when a stock has its lowest or sell it when it reaches peak value. The buy or sell decision is determined by an investor’s prediction of share price movements and can be based on any number of analytics, from technical stock analysis to tea leaf reading.
I jest? For most of us — and judging by their record, for timing strategists too, as they are as often right as they are wrong.
“We ignore outlooks and forecasts…” We’re lousy at it and we admit it …” Everyone else is lousy too, but most people won’t admit it.”
— Martin Whitman
Market timing is vexing for anyone, pro or amateur. The best advice is not to do it. I know. Knowledge often comes from bad experiences, and if you have ever been an active investor, you know this lesson. A decade or two ago, we bought a bunch of Nortel, a former Canadian high-flyer large cap tech stock at what turned out to be 75% of the way to its peak price. Following our strategy, we sold half of the stock at a reasonable profit — but then, instead of selling the rest, we got greedy and waited for more! Sure enough, the price kept climbing. And we waited. Then it started sinking. This can’t be for real, we said as it sank below our buying price. We tried to dollar-cost average for a win, buying more stocks as the price declined. Moral of this story: We never sold, and Nortel went the way of the Dodo simply because it sold wires and switch boxes and didn’t keep up with wireless innovation. (I keep the stock valued at $0.0001 in our portfolio as a reminder about timing.)
Those who have knowledge don’t predict. Those who predict don’t have knowledge.
— Lao Tzu
Unfortunately, there are many such sad investment stories to learn from, and unfortunately, logic does not always make an investor decide on the best course. Take the very good friend of Jason from DC, who freaked out in the 2008–09 market meltdown and sold off almost all his holdings. Jason’s best efforts to convince his friend that the market would return did nothing to sway him, and his friend wound up losing more than half his pre-crash portfolio by selling. Had he waited, he would have ridden a market that saw an over-100% appreciation by 2013.
If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.
— George Soros
If you are the type who has the knowledge, time, and interest and can withstand the vicissitudes of the market without breaking into shingles at the least negative news, trade away. Even if you are not of this type, you still need to get involved in your portfolio management. Just not directly. Get help from an adviser.
The advice you get in this or any other book, from one adviser or another, should be simple and straightforward. For the average middle- to upper-income earner, investment can and should be simple. Develop an asset allocation plan suited to your risk tolerance. Buy and sell investments matching your long-term needs, with more holding than selling. Do this yourself or with your adviser. More than this you can do. But your investment risk might go up.
Boring advice? You bet. But it may not be all that dull, once you know that even with very low levels of risk tolerance, some very stimulating sustainability investments are waiting just for you.
• There are three main categories of investment: equities (with various categories of investment risk), fixed income, and cash.
• You need to develop an asset allocation plan to best meet your
° investment goals — how much you want to make on your investments,
° risk tolerance — how afraid or unafraid you are of putting money in the market,
° investment horizon — how long it will be before you need the money you are investing.
• In practice, asset allocation means how much equity, bonds, or cash you hold in your portfolio, as a percentage of your total capital.
• You shouldn’t time the markets, rather trust long-term, patient investment.
• If you don’t feel good about managing your finances, don’t. Seek an adviser.
• Celebrate making it through this chapter by doing something completely void of definitions or numbers!