This is the first of several guest posts by Nathan Bush on 12 investing concepts.
CONCEPT ONE—RISK-ASSET ALLOCATION (A/A)
An investment in stocks is a risky venture. One would hope for high return but it does not always work out that way. Stock values can (and often do) go down; they are volatile. Historically, they go up more often than they go down but sometime they can stay depressed for extended periods. An investment in Bonds or Fixed Income Instruments is also risky and can go up or down, but to a much lesser degree. They tend to move in value much less drastically in both speed and direction. Typically (but not always) bonds move in the opposite direction of stocks. Stocks go down and bonds go up and vice versa. Because of this divergent risk, stocks tend to have a higher return (risk premium); and since bonds are less risky, they have a lower return. The mix of stocks and bonds is called an Asset Allocation (A/A) and is expressed as a percentage of each to the total; i.e. 60% stocks and 40% bonds would be expressed as 60/40. The greater the percentage of stocks is, the more aggressive the portfolio. This is the biggest factor for determining the return of the portfolio. An A/A of 60/40 is considered to be a moderate allocation. Notice that the A/A of the Hypo-Folio is 70/30… a little more aggressive.
The father of “Value” investing, Ben Graham (Warren Buffet’s professor and mentor) has stated that one should always have some risk, but not too much; no less than 25% and no more than 75%, or between 25/75 and 75/25. It all depends on ones NEED, ABILITY, and WILLINGNESS to take risk. The stock section of your portfolio “Lets you eat well” and the bond section “lets you sleep well”. This is the Sleep Well at Night (SWAN) theory.
Other risk factors are inflation and single security risk. Inflation can be mitigated with inflation protected bonds and shorter-term bonds. Single security risk can be mitigated by holding multiple securities…they will not all go down at the same time.
This is the Holy Grail of investing. Just about everybody knows the old saying, “Don’t put all your eggs in one basket”. When investing you need to spread your investments across many asset types, geographic locations, stock sectors, and any other diversifying factors you can find. Spread the risk. Stock pickers suggest that 15 to 20 individual stocks will give you sufficient diversification. Indexers suggest that broad market indexes across all U.S. and international markets with several thousand stocks are infinitely better. You do not have to look for the needle in the haystack…just buy the whole haystack.
In the Hypo-Folio:
SCHB—Index of almost all (80% by # and 95% by $ Value) of the stocks in the U.S. market (mostly Large Cap).
VBR—Index of U.S. Small Cap (with a few Mid Cap) stocks (the other 20%)
SCHF—Index of almost all the foreign stocks in Europe, Australia and the Far East (EAFE). The Developed World except the U.S.
SCHE—Index of stocks in the Emerging World markets, including Brazil, Russia, India and China (BRIC’S) plus another 20 or so countries.
VSS—Small cap stocks in the international Markets (VBR &VSS are my “Small Cap TILTS”)
These five Exchange Traded Funds (ETF’s) cover the entire Haystack of investable equities.
For the Fixed Income portion of the Hypo-Folio I use:
SCHZ—A broad market, intermediate term U.S. Government Bond Fund.
SCHP—An index of Treasury Inflation Protested (TIP’s) Bonds.
I-Bonds—a variety of paper I-Bonds purchased between 2002 and 2006, at various adjustable rates.
CASH—Cash in banks checking and savings accounts.
All the above fixed income items have virtually no principal risk (government guaranties), the TIP’s and the I-Bonds are inflation protected. I-Bonds can be converted to a “529” college savings plan without taxes or a withdrawal penalty. I also consider the I-Bonds and cash as my Emergency Fund.