We already established that passively-managed, or index, funds are great investment vehicles for buy & hold investors. Someone may say "Alright then, lets allocate our money in one super duper well-diversified index fund and that's all", but it is not that simple. Most good portfolios contain both stocks and bonds, from U.S. and international origins, including small-cap and emerging-market stock. Their ideal proportions depend on the investment objectives and the risk-absorption capacity of the owners. Hence, fund companies rarely offer one-fund solutions. Instead, they provide the building blocks for you to assemble a portfolio that matches your preferences. Normally, you would only resort to a single-fund portfolio if you are investing very little money and you either don't want your earnings to be diluted by transaction fees, or you cannot reach purchasing minimums for more than one fund (if such minimums exist).
Therefore, an important step in portfolio construction is deciding how big a portion to allocate in each asset class. What percentage will you invest in stock and how much in bonds? What portion will you reserve for international securities? Will you assign some to emerging markets? What about small and mid-cap stock vs. large-cap?
Fixed-income vs. stock
The first of those questions will have the greatest effect on the portfolio's outcome. Fixed income is less volatile than stock, so the proportion of bonds to stock pretty much defines the level of risk of you portfolio. But be careful, not all bonds are the same. As we shall later see, those with lower credit quality behave more like stock. Besides, many fixed income funds employ a profit-augmenting technique called financial leverage that increases volatility. Thus, low-credit-quality fixed-income funds that are leveraged are about as risky as stock. Adding them to a stock portfolio will diversify it a bit (not too much because there is high correlation between stock and low-credit-quality bonds) but it will not make it as safe as adding good-credit-quality unleveraged funds.
The ideal proportion of stock to bonds depends on your credit absorption capacity, which in turn depends on your investment horizon (this is the length of time of your investment). If you are planning to use that money in two or three years, your investment horizon is kind of short, so you rather allocate more in fixed income, in case there is a dip in the stock market. But if you are going to keep that money invested for ten years or more, that's enough time for the market to compensate, through good (bull) periods, for downfalls that might occur. Therefore, the first case would recommend an allocation of about a 50% in fixed income and the rest in stock, depending on how much risk you are willing to take, while the latter could use an 80% in stock and 20% in bonds, or even all stock if you wish. It is a good idea, as you are getting closer to withdrawing the money, to change the allocation to a more conservative one.
Local vs. international
International stock shares are good diversifiers, even though globalization is nowadays extending the effect of local bonanzas and crisis to the whole world, so don't expect them to be excellent ones. The country allocation of your portfolio should be based on where you live, or more precisely, on where you plan to spend the outcome of your investment. If your country performs poorly, you won't have such a big problem, because the expenses that you will cover with the investment results will probably be low too, because of that poor financial performance. But if most of your investment is allocated somewhere else, it threatens you that the other country might perform worse than yours. Therefore, if you live in a developed country, it makes sense to allocate at least a 40% in it. If your country is not developed, you may prefer to allocate a little less, to have most of your investment in more stable economies. The rest should be diversified throughout the world.
Emerging markets and small/mid caps
The developed world includes the US, Europe (except Eastern) and Japan, plus smaller economies such as Australia, Canada, Singapore, South Korea, Taiwan and Israel (Hong Kong could be included but it is a special case). Other regions of the world are developing their economies and their stock markets at a fast rate. China, India, South America and Eastern Europe (including Russia) are worth mentioning. These emerging markets tend to be more risky, because they don't have as much financial strength as developed economies, but in exchange they offer better profits, and they are decent diversifiers. It is therefore a good idea to invest about a 20% of your portfolio in emerging-market stocks and bonds.
Similarly, small and medium cap stock can diversify and spice up a large-cap portfolio, because they also tend to be more risky and more profitable. It sounds good to have about a 25% of the portfolio placed on small and/or medium capitalization companies.
« What are Index Funds? | Guide to Investing | (Next part coming soon) » |
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