Jane Young, CFP, EA
Many investors think of investing as a competition between investing in the stock market, interest earning investments and real estate. Too many people take a strong stance for or against one of these three broad categories rather than embracing the advantages that each one can bring to their portfolio. A well balanced portfolio should include some of all three with each serving a very different purpose.
All three categories will have their day in the sun depending on the investment climate. Due to low rates, interest earning investments such as CDs, bonds and savings accounts aren’t getting much love right now. Despite the current low rates of return, interest earning investments provide a relatively safe place to keep your short term money. This is money needed to cover living expenses or emergencies over the next several years. Interest earning investments provide a buffer against more volatile investments in the stock and real estate markets. Keeping a portion of your portfolio in safer, fixed income investments can give you greater peace of mind and help you stick to your long term plan when the stock market gets rocky. However, avoid putting too much in interest earning investments; this can make it difficult to keep up with inflation and earn the growth needed to support your retirement goals.
On the other hand, when the stock market is doing well everyone wants to get a piece of the action. Avoid overloading your portfolio with stock when the market is skyrocketing. Investments in the stock market can provide you with long term growth and a hedge against inflation. Historically, the stock market has trended upward and over long periods of time has outperformed other investment categories. However, in the short term the stock market can be very unpredictable and volatile and should only be used for long term needs – money that isn’t needed for five to ten years. Keep your short term money in interest earning investments.
Real estate serves a dual purpose for most investors, it gives us a place to live and it provides us with an asset that usually appreciates over time. In addition to your home, as your portfolio grows, you may want to consider additional real estate investments in mutual funds or rental property. Like the stock market, real estate should be treated as a long term investment. The real estate market can experience extreme downturns and commonly lacks the liquidity needed to cover short term needs.
These three categories of investments have their advantages and disadvantages. Focus on the role the asset plays in your financial plan and avoid becoming overly comfortable and confident with a single category – it’s all about balance. The appropriate amount in each category will vary over time and is dependent on your age, your financial goals, your cash flow needs and your risk tolerance.
Jane Young, CFP, EA
The recent increase in the stock market is making a lot of investors nervous about the possibility of a significant correction. I am frequently asked what the market will do over the next few months. In reality, no one can predict market performance, especially in the short term. Your best defense against a volatile stock market is to create a financial plan and an asset allocation that is appropriate for your financial situation and time horizon.
If your current asset allocation is in line with your financial goals, there’s probably no need to make major adjustments to your current portfolio. Your asset allocation defines the percentage of different types of investments such as U.S. stock mutual funds, international funds, bond funds and CDs that are held in your portfolio. You should establish an asset allocation that corresponds with the timeframe of when your money will be needed. Investments in the stock market should be limited to money that isn’t needed for at least 5 to 10 years. Keep money that may be needed for emergencies and short term expenses in safe, fixed income investments like bank accounts, CDs or short term bond funds.
The stock market is inherently volatile and there will be years with negative returns. However, over long periods of time the market has trended upward with average annual returns on the S&P 500 exceeding 9% (approximately 7% when adjusted for inflation). It’s important to consider your emotional risk tolerance in establishing your asset allocation. You may have the time horizon to have a significant portion of your portfolio in stocks but you may not have the emotional tolerance. Your asset allocation may be too risky if you are tempted to sell whenever the market goes down or you are continually worried about your investments in the stock market.
Establishing an asset allocation that meets your situation can help your ride out fluctuations in the stock market more effectively than trying to anticipate movements in the market. It’s impossible to time the market and a short term increase is just as likely to occur as a drop in the market. Although you want to avoid timing the market, you should rebalance your portfolio on an annual basis to maintain your target asset allocation. Additionally, you will want to adjust your target allocation over time as your financial situation changes and you move through different phases of life.
Keeping other areas of your financial life in order can also help you through a major market adjustment. It’s essential to maintain an emergency fund of at least 3 to 6 months of expenses, make a habit of spending less than you earn, and save at least 10 -15% of your income.
Rather than focusing on where the market is headed and what the financial pundits are predicting, maintain an appropriate asset allocation and keep your financial affairs in order.
Jane Young, CFP, EA
Deciding upon an asset allocation is one of the first and most significant decisions to be made when you start investing. Your asset allocation is the percentage of different types of investments such as cash, bonds, stock or real estate that make up your investment portfolio. Probably one of the most important allocations is that between investments in the stock market and investments in interest earning vehicles such as bank accounts, CDs and bonds. An ideal asset allocation provides a balance between risk and return that helps you meet your goals but doesn’t keep you awake at night.
There is a trade-off between risk and return. Generally, if you want a higher return you need to assume a higher level of risk. Investment risk comes in many different forms with the most common being stock market risk. Historically, over long periods of time, the stock market has out-performed most other investments. However, in the short term it can be extremely volatile, including years with negative returns. In the extreme case you could lose your entire investment in an individual stock. To reduce risk in the stock portion of your portfolio, consider buying diversified stock mutual funds. You will still experience swings in the market but fluctuations in any one stock will have less impact.
On the other hand, interest earning investments such as bank accounts, CDs, bonds and bond funds are generally less risky and are not subject to stock market fluctuations. Unfortunately, in exchange for this lower level of risk you may earn a much lower rate of return.
Additionally, bonds and bond funds are subject to interest rate risk and default risk. If you purchase a bond or bond fund and interest rates increase, the value of your investment will decrease. To make matters worse, when interest rates rise bond funds commonly experience a flood of redemptions forcing them to sell bonds within the fund at a loss. Even if you hold on to your shares you can experience a drop in value. However, if you purchase an individual bond and hold it till maturity you will receive the full value upon redemption. Use caution when buying low quality bonds or bond funds; you may get a higher return but you are subject to a much greater risk of default.
Many investors don’t consider inflation risk. This results from taking too little risk with a conservative portfolio containing little or no stock. Over time inflation has averaged about 3% annually, if you are only earning 2% on your portfolio your real return after inflation will be negative. This is compounded if inflation rates rise significantly. Consider increasing your allocation in the stock market to hedge against inflation risk.
In the current environment of low interest rates and high volatility it’s crucial to build a portfolio that balances risk and return to support your financial goals and provide you with peace of mind.
Jane Young, CFP, EA
We recently built a new home and have been feverishly working on landscaping and planting new flower beds. While going through the process of planting and nurturing my flower gardens I realized there are many similarities between gardening and investing. I planted a lot of perennials to create a garden that will last for many years. However, I’m anxious for the perennials to grow into the large, colorful flowers I have envisioned. I realize it takes time and patience to develop a gorgeous garden. To satiate my immediate need for some color I interspersed some annuals with the perennials. The annuals will meet my short term needs but aren’t a good long term investment. They will provide beautiful color this year but will die and won’t return next spring
To build a successful garden you have to plan ahead, prepare the earth and plant seeds long before reaping the benefits. Investing is similar to gardening in that you need to think ahead to create a plan that will meet your long term objectives. You have to start by planting the seeds and continue feeding and nurturing your investment plan. After your initial investment is made, continue making contributions and annually re-balance your portfolio to be sure you stay on track. Periodically some weeding is required to remove poor performing or inappropriate investments from your portfolio. You may also need to add some nutrients by adding better performing mutual funds or by expanding on the categories of funds in which you are invested.
It’s essential to meet short term needs. This year I had a short term need for some annuals to add color to the garden. In your portfolio, you need to include short term money for emergencies and living expenses. If short term needs are addressed you can invest your long term money more effectively with greater confidence.
Additionally, in both gardening and investing it’s important to stay diversified. My garden has a variety of flowers that bloom at different times of the year or react differently to varying weather conditions. Your portfolio should also be diversified with a variety of different investments that help you buffer against a variety of market conditions and changes in your personal life.
Just like perennials in the garden, investments in your portfolio need time to grow and absorb fluctuations in the market. If you become impatient and give up before they have time to fully bloom you won’t meet your end goal. Just as vibrant short term annuals can provide a lot of immediate satisfaction they don’t result in a garden that is sustainable over many years.
Investing, as in gardening, is a slow and steady process. Get started, set a plan, keep a long term perspective and stick to your plan. Patience and perseverance will help you build a gorgeous garden and a more secure financial future.