People who have accumulated enough capital to begin investing in the market can face some daunting challenges — none greater than trying to figure out how to invest that capital.
Building a portfolio is easy. Building the right portfolio takes discipline and most of all, risk awareness. The greatest favor investors can do for themselves is to determine goals and invest according to associated time horizons. A diversified portfolio should have a long-term time horizon of at least 10 to 20 years.
“There might be different buckets of money for different goals,” says Davi Kutner, director of wealth management and senior financial advisor at HA&W Wealth Management in Atlanta. “You might want to save for a down payment on a home; for this, a CD or money market fund might be the way to go, even though they are not paying much at all right now. For investors with time horizons of 20-plus years, the stock market has historically been a good place to invest.”
The trick, however, is creating a truly diversified portfolio. That’s where most investors make mistakes.
“The key to building a portfolio is to have investments with different levels of risk,” says Ed Butowsky, managing partner of Chapwood Investments in Addison, Texas. “A lot of investors have what I call ‘naïve diversification,’ in that they believe that having a lot of investments is what makes a portfolio diverse.”
The number of investments isn’t what matters, Butowsky says. It’s how risk is spread across those investments. Not even money managers diversify properly. “Naïve diversification is one of the great tragedies in money management today,” he says.
What kind of diversification truly spreads the risk around? The stock market offers many classes of investment. Although not a complete list, the most well-known classes of stock investments are:
— Large company growth
— Large company value
— Midsize company growth
— Midsize company value
— Small company growth
— Small company value
— International
— Emerging markets
— Real estate
— Commodities
— Fixed income (bonds)
The amount of money you put into each category depends on many factors and goes back to risk assessment. Generally speaking, the smaller the company is, the more risk it is likely to have, but it is also likely to have a higher reward over time. Smaller companies provide larger returns as they become bigger companies. Bigger companies have less room to grow since they are already large.
Butowsky advises to invest in stocks, rather than rely on fixed-income securities.
“Regression analysis shows that if you are a moderate risk-taker with a time horizon of 10 years or more, you should have 89 percent of your capital in stocks,” he says. This contrasts with more arbitrary standards of having 60 percent to 70 percent in stocks.
“That makes no sense at all. First, it’s arbitrary and not based on data. Second, the only 10-year periods where investors lost money in stocks was 1927 to 1937 and 1928 to 1938. The average amount lost was only 1 percent. That includes dividends being re-invested, by the way,” Butowsky says.
While most investors younger than 40 can tolerate volatility and can be invested in the stock market, Kutner suggests having a reasonable weight toward fixed-income securities once investors reach age 50 to create some stability. For those who are in retirement and are relying heavily on income from an investment portfolio, “a higher weighting to fixed income should be considered,” he says.
What about the best time to enter the stock market? “I do not believe there is a right or wrong time to enter the stock market,” Kutner says. “The short-term movement of the market is truly unknowable. For those who have a long time horizon and who are adding funds to the portfolio on a consistent basis, it is best to get in when you have the funds available.”
Butowsky agrees. He says to ignore how pundits evaluate the market and pay attention to what legendary investor Peter Lynch said: Stock prices follow company earnings.
“The stock market as a whole is not expensive. Everyone is caught up in what the Dow Jones industrial average says, and that number is irrelevant. The only things an investor should care about is the [price-to-earnings] ratio and where interest rates are.”
Butwosky says a good general guideline is to compare a company’s earnings growth rate with its P/E ratio. If that growth rate is greater than or equal to the P/E ratio, you may have a bargain on your hands. “If the growth rate is much less than the P/E ratio, you may be looking at a relatively expensive stock,” he says.
Investors shouldn’t leave their portfolios entirely alone. Every six months or so, Butowsky suggests investors should rebalance or re-allocate capital among the different sectors if some have exceeded or declined past the original target allocation. If one targets 10 percent allocation for large-capitalization stocks and it becomes 14 percent of the portfolio, then 4 percent needs to be sold off and reallocated into the asset class that has been depleted.
For those who are nervous about buying individual stocks, the market has innovated away from mutual funds into easily tradable securities called exchange-traded funds. These operate exactly like mutual funds, in that each holds a basket of stocks for a given asset class. Thus, rather than buying 50 stocks across all the different classes, investors could just buy a handful of ETFs and have very broad exposure to the entire market.
Kutner thinks the approach has merit. “For a first portfolio, one might look at some very broad index funds or ETFs. Having exposure to both U.S. markets as well as international markets may be something to consider,” he says.
Butowsky adds that the more conservative an investor is, the more he or she may want to concentrate investments into things like ETFs that carry utilities and preferred stocks. They pay nice dividends and tend to be insulated from international earnings disappointments.
The final piece of advice for building one’s portfolio is not to tear it down in a panic. If the market should crash, as it did by 55 percent in 2008 and 2009, “Invest as much fresh cash into the stock market as you can,” Kutner says. “This is probably the time to make some sacrifices on current spending in order to put additional cash into the markets. Shorter-term penny-pinching could payoff nicely in the long run.”
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How to Create the Right Investing Portfolio for You originally appeared on usnews.com
