Investment Basics

What is an Investment

According to Wikipedia: Investment is traditionally defined as the “commitment of resources to achieve later benefits”. If an investment involves money, then it can be defined as a “commitment of money to receive more money later”. From a broader viewpoint, an investment can be defined as “to tailor the pattern of expenditure and receipt of resources to optimise the desirable patterns of these flows”. When expenditure and receipts are defined in terms of money, then the net monetary receipt in a time period is termed as cash flow, while money received in a series of several time periods is termed as cash flow stream. Investment science is the application of scientific tools (usually mathematical) for investments.

In personal finance, the purpose of investing is to generate a return from your invested asset. The return may consist of a gain (profit) or a loss realized from the sale of an investment, unrealized capital appreciation (or depreciation), or investment income such as dividends, interest, or rental income, or a combination of capital gain and income.

Investors generally expect higher returns from riskier investments. When a low-risk investment is made, the return is also generally low. Similarly, high risk comes with a chance of high losses.

Investors, particularly new investors, are advised to diversify their portfolio. Diversification has the statistical effect of reducing overall risk and Diversification is one of the four investment strategies we will discuss that are designed to help you minimize risk and maximize returns.

4 Investment Strategies

These are the most common and most powerful investment strategies available to young and old investors alike, designed to help you maximize returns and minimize risk so that you build more wealth over time:

• Diversification

• Asset Allocation

• Dollar-Cost-Averaging

• Portfolio Rebalancing

What Is Diversification?

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.

The Basics of Diversification

Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated—that is, they respond differently, often in opposing ways, to market influences.

Which Elevator is More Secure?

The most basic — and effective — strategy for minimizing risk is diversification. Diversification is based heavily on the concepts of correlation and risk. A well-diversified portfolio will consist of different types of securities from diverse industries that have varying degrees of risk and correlation with each other’s returns.

While most investment professionals agree that diversification can’t guarantee against a loss, it is the most important component to helping an investor reach long-range financial goals, while minimizing risk.

There are several ways to plan for and ensure adequate diversification including: 

1. Spread your portfolio among many different investment vehicles — including cash, stocks, bonds, mutual funds, ETFs and other funds. Look for assets whose returns haven’t historically moved in the same direction and to the same degree. That way, if part of your portfolio is declining, the rest may still be growing.

2. Stay diversified within each type of investment. Include securities that vary by sector, industry, region, and market capitalization. It’s also a good idea to mix styles too, such as growth, income, and value. The same goes for bonds: consider varying maturities and credit qualities.

3. Include securities that vary in risk. You‘re not restricted to picking only blue-chip stocks. In fact, the opposite is true. Picking different investments with different rates of return will ensure that large gains offset losses in other areas.

Keep in mind that portfolio diversification is not a one-time task. Investors and businesses perform regular “check-ups” or rebalancing to make sure their portfolios have a risk level that’s consistent with their financial strategy and goals.

Diversification Remembering Enron

The collapse of Enron dominated the business news here in Houston and around the world. In fact, for some people I know, the Enron story was painfully personal.

In the years just prior to the company’s collapse, the company urged employees to keep all their retirement funds in Enron stock.

One of my clients realized that was a risk she wasn’t willing to take, but another client bought the company’s promises of long-term stability.

Beth came to me a few months after the company filed bankruptcy. For all intents and purposes, Enron had ceased to exist, but she had a huge amount of money to invest. I asked, “How did you get out of there with all this money?”

She replied, “I saw the writing on the wall, so I took my money out of Enron stock well before it tanked, and I put it in other funds.”

Today, Beth’s retirement account is doing quite well.

But Frank didn’t see the writing on the wall. He believed the officers who told him, “Don’t worry. Everything will be just fine.”

In the heyday of the company, Frank had over $1 million in Enron stock in his retirement account. A few months later, he had nothing.

The financial setback was too much for him. The pain and shame caused panic attacks, then a heart attack. Frank died as another casualty of Enron’s financial mismanagement.

Diversification is a way to spread risk so the problem Frank experienced doesn’t happen to you.

My favorite illustration comes from my friend David Coney at Edward Jones. David taught me to illustrate diversification by talking about elevators.

 

I tell the client she has a choice of two elevators. A single cable holds up one elevator, and eight strong cables hold the other. The building, I tell the client, is 100 years old.

Then I ask, “Which elevator would you take to the top floor?”

This question often elicits a chuckle and a quick reply, “The one with lots of cables.”

The single cable may be strong for a long time, but if and when it ever breaks, people in the elevator will be in trouble.

But if one of the eight cables on the other one breaks, the other cables can hold it very securely.

This simple drawing illustrates the difference between trusting in one financial product (that is, “putting all your eggs in one basket”) and having a diverse portfolio.

This illustration also describes the benefits of mutual funds, Index Funds, or ETFs over individual stocks. In a mutual fund, the managers check the cables (individual stocks) in their diversified holdings, and replace those that aren’t performing well or have too much risk.

It’s sound, established, financial logic to avoid having too many assets in a single investment, but some executives, managers, and employees view their company’s stock like it’s their first-born child.

For example, one man told me, “I’d never sell my company’s stock. I’d feel disloyal.” We talked further about the benefits of diversifying, and ultimately, logic prevailed. Some people, however, won’t budge. Their emotional investment in their pet stock is so strong that they simply can’t bring themselves to sell any portion of it.

Asset Allocation Takes the Cake

The distribution of assets to balance risk and reward is the most important principle of investing. A little wisdom makes a huge difference in the return on investment.

A lady named Kimberly came to me, and she was visibly upset. Her husband Ed had an IRA with $100,000, but he had kept it in a money market at .5% during five years the market had gained 10 to 16% each year. They were both about 35 years old.

Dozens of times, she had suggested that he move his money to more productive instruments, and finally, he agreed to meet with me. I explained asset allocation, and they both felt much more comfortable about investing the money.

Asset Classes

In order to implement the 4 Investment Strategies outlined in today’s lesson, it is very important that you understand the differences between asset classes. There are many many different asset classes, sometimes referred to as “styles”:

• US Large Cap

• US Mid Cap

• US Small Cap

• International

• US Government Bonds

• US Corporate Bonds

• Municipal Bonds

• International Bonds

• And the list goes on and on…

 

Three Big Factors

Three factors determine the performance of your portfolio:

• Asset Allocation,

• The Selection of Assets (Stock Picking), and

• Market Timing

In a ten-year study of ninety-one large corporate pension plans in the United States, the authors of an article in Financial Analysts Journal found that…

94% Of Performance Was Determined By Asset Allocation.

What is Asset Allocation

Investment selection accounted for only 4%, and market timing was responsible for 2%. B.G.P. Brinson, B.D. Singer, and G.I. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal (January/February, 1986.)

The metaphor I use to explain asset allocation is balancing a tire for high speed driving. When I was a mechanic, and a customer came to my shop because the car was shaking, the problem was almost always that a tire was out of balance, sometimes caused by a small bump of rubber from uneven wear.

Even a seemingly small imbalance of a quarter of an ounce could cause the tire to shake violently at high speeds. I applied a weight to counterbalance the wheel.

We checked it on the balancing machine to be sure it ran smoothly, put it back on the car, and the customer was ready to go.

Asset allocation balances the portfolio, so the assets run smoothly toward your goals. Sometimes people only need to make small adjustments, but often they need to make major changes in the distribution of assets.

Some people are so risk-averse that they want to keep all their money in cash, and they want to divide it up so they stay under the FDIC limits in each institution.

But this strategy only limits risk in the immediate future. Returns on cash accounts don’t even keep pace with inflation, so there is no opportunity for asset appreciation and they actually increase their long-term risk.

What is Dollar Cost Averaging

The best way to develop a substantial nest egg is to develop the discipline of putting money into a fund every month—no excuses. The market will go up or down, but our funds continue to grow slowly and steadily. I know people who began putting as little as $25 a month into an investment, and over time, they’ve accumulated a substantial amount of money.

When they were young, they had every reason to put off investing because they could easily use that $25 for dinner and a movie. But they were committed to save and invest, even if it was a small amount. When they got promotions and raises, they increased the amount they put away each month.

Dollar Cost Averaging with Farmer Joe

Many of us are tempted to wait for a windfall—winning the lottery or a big inheritance from Aunt Phoebe—before we even start to invest. Our hopes are high because we’ve heard stories of people who hit it big, but those stories are in the news because they’re so rare, not because they’re commonplace.

To explain the benefit of regular investing, I use the illustration of a farmer who invests each month in his favorite commodity: Cows.

Farmer Joe calls me and wants to invest $100 each month. When he begins, the market for cattle is near an all-time high. Cows are selling for $100 a head (which actually includes the entire cow, not just the head in case you’re watching Netflix while you’re reading this…).

He wonders if this is the right time to invest, but he needs more cattle.

• The first month, he can buy only one cow. 

• In the second month, the price of cattle goes down to $50, so he buys two.

• The third month, the price goes to $25, so he buys four that month.

• And in the fourth month, the price of cattle plummets to a low: $20 each.

At that point he calls me and says, “Hey bucko, what have you gotten me into? Cattle are $20 a head! I bought all these cattle at high prices, and the bottom has dropped out of the market! I’m going to sell them all and cut my losses.”

I tell him confidently, “Farmer Joe, the market is very low right now. You were paying $100 a head four months ago.

You needed cattle, didn’t you? Has that changed? No? So why are you upset?

This is the best time to buy cattle, not sell. Hang in there.

You’re in great shape to benefit from this phase of the cycle.”

Farmer Joe bites his lip and decides to trust me.

• The next month, the price creeps up to $25 again. Farmer Joe buys four head.

• The next month, the price has risen to $50, so he buys two, and

• The next month, the price of cattle is back up to its high of $100, and he buys only one head.

At that point, Farmer Joe decides to sell. During those seven months, he bought nineteen cows for a total of $700. They’re worth $1900, yielding a net profit of $1200, and the price of cattle never rose above $100 a head.

Farmer Joe’s only regret was that he didn’t sell his tractor and buy more cattle when they were $20 each.

As I explain this story, I draw a chart for my clients. It looks something like the cow chart used in the beginning of this article (except that my cows never look that good).

Portfolio Rebalancing

Portfolio Rebalancing is Like Balancing a Tire, it’s the process of realigning the weightings of assets in your investment portfolio. Rebalancing involves periodically buying or selling securities to maintain an original or desired or risk level.

For example, say your original target was 25% small cap stocks, 25% large cap stocks, 25% international stocks and 25% bonds. If the small stocks performed well during the period, it could have increased the small cap stock weighting of the portfolio to 40%. At the same time, your bonds may have gone down so much that your bond allocation is now only 15%. So, you may then decide to sell some small cap stocks at this higher price and buy more bonds at this lower price to get your portfolio back to the original target allocation of 25/25/25/25

What is Portfolio Rebalancing

Portfolio rebalancing safeguards you from being overly exposed to undesirable risks — like way too much international stock in your portfolio.

These steps are taken to ensure the amount of risk involved is at your desired level. As stock performance can vary more dramatically than bonds, the percentage of assets associated with stocks will change with market conditions. Along with the performance variable, investors may adjust the overall risk within their portfolios to meet changing financial needs.

“Rebalancing,“ as a term, has connotations regarding an even distribution of assets; however, a 25/25/25/25 stock and bond split is not required. Instead, rebalancing a portfolio involves the reallocation of assets to a defined makeup. This applies whether the target allocation is 50/50, 70/30, 40/60, or 25/25/25/25 as in the example I used above.

While there is no required schedule for rebalancing your portfolio, most recommendations are to examine allocations at least once a year. It is possible to go without rebalancing your portfolio, however, regular rebalancing is one way to maximize returns AND minimize risk.

Portfolio Rebalancing gives you the opportunity to sell high and buy low, taking the gains from high-performing investments and reinvesting them in areas that have not yet experienced a lot of growth.

Calendar rebalancing is the most basic rebalancing approach. It can be done quarterly, annually, or every six months. This investment strategy simply involves analyzing your investment holdings within your portfolio at predetermined time intervals and adjusting to the original allocation at your desired frequency.

Monthly or quarterly assessments are typically preferred because weekly rebalancing would be overly expensive while a yearly approach would allow for too much portfolio drift.

The ideal frequency of rebalancing can be determined based on your time constraints, transaction costs, the options available through your custodian or 401k sponsor. A major advantage of calendar rebalancing over more responsive methods is that it is significantly less time consuming and costly for since it involves less trades and at pre-determined dates. The downside, however, is that it does not allow for rebalancing at other dates even if the market moves significantly. So, when the markets move significantly, you can take a more responsive approach to portfolio rebalancing.

Portfolio Rebalancing Summary

• Rebalancing is the act of adjusting your portfolio asset weights in order to restore target allocations or risk levels over time.

• There are several strategies for rebalancing such as calendar-based, corridor-based, or portfolio-insurance based.

• Calendar rebalancing is the least costly but is not responsive to market fluctuations, meanwhile a constant mix strategy is responsive but more costly to put to use.

Rebalancing Retirement Accounts

One of the most common and important ways to rebalance are the allocations within your retirement accounts — remember The Perfect Investment? Hint, it starts with 401K. Asset Allocation impacts your overall performance and many investors prefer to invest more aggressively at younger ages and more conservatively as they approach retirement age. Often, the portfolio is at its most conservative as you prepare to draw out funds to supply retirement income.

Rebalancing for Diversification

Depending on market performance, investors may find a large number of current assets held within one area. For example, should the value of Tesla may increase by 25% while GM only gained 5%, a large amount of the value in the portfolio is tied to the Tesla stock. Should Tesla experience a sudden downturn, your portfolio will suffer higher losses by association. Rebalancing lets you redirect some of the funds currently held in Tesla to another investment (maybe Apple or Microsoft or McDonalds).

By keeping your funds spread out across multiple stocks — and multiple asset classes — a downturn in one will be partially offset by the activities of the others, which can help you maximize returns while minimizing risk over time.

Asset Classes

In order to implement the 4 Investment Strategies outlined in today’s lesson, it is very important that you understand the differences between asset classes. There are many many different asset classes, sometimes referred to as “styles”:

• US Large Cap

• US Mid Cap

• US Small Cap

• International

• US Government Bonds

• US Corporate Bonds

• Municipal Bonds

• International Bonds

• And the list goes on and on…

## Diversification

The most basic — and effective — strategy for minimizing risk is diversification. Diversification is based heavily on the concepts of correlation and risk. A well-diversified portfolio will consist of different types of securities from diverse industries that have varying degrees of risk and correlation with each other’s returns.

Asset Allocation Takes the Cake

The distribution of assets to balance risk and reward is the most important principle of investing. A little wisdom makes a huge difference in the return on investment.

A lady named Kimberly came to me, and she was visibly upset. Her husband Ed had an IRA with $100,000, but he had kept it in a money market at .5% during five years the market had gained 10 to 16% each year. They were both about 35 years old.

Dozens of times, she had suggested that he move his money to more productive instruments, and finally, he agreed to meet with me. I explained asset allocation, and they both felt much more comfortable about investing the money.

Inflation is a Big Risk

They understood inflation was a big risk to their future, but properly allocating their assets in the market would help them balance risk and return. When I showed them the math, they were stunned.

Here’s what I explained: If they kept that $100,000 in the money market (cash) account at .5% from age 35 to age 65, the account would be worth only $116,140. By investing their 401k into a diversified family of mutual funds with an expected return of 8% compounded annually, the amount would jump to $1,006,265!

• Kimberley and Ed almost fought each other to see who would sign the papers to move the funds.

• Asset allocation needs to factor in these elements:

• Your risk tolerance, which determines how aggressive or conservative your investments will be,

• The time horizon for achieving your stated goals, such as college education for a child in 2 years and retirement in 35 years, and

• The market dynamics of cash, bonds, equities, and real estate and their relationship to one another to maximize returns while minimizing risk.

Three Big Factors

Three factors determine the performance of your portfolio:

• Asset Allocation,

• The Selection of Assets (Stock Picking), and

• Market Timing

In a ten-year study of ninety-one large corporate pension plans in the United States, the authors of an article in Financial Analysts Journal found that…

94% Of Performance Was Determined By Asset Allocation.

Investment selection accounted for only 4%, and market timing was responsible for 2%. B.G.P. Brinson, B.D. Singer, and G.I. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal (January/February, 1986.)

The metaphor I use to explain asset allocation is balancing a tire for high speed driving. When I was a mechanic, and a customer came to my shop because the car was shaking, the problem was almost always that a tire was out of balance, sometimes caused by a small bump of rubber from uneven wear.

Even a seemingly small imbalance of a quarter of an ounce could cause the tire to shake violently at high speeds. I applied a weight to counterbalance the wheel.

We checked it on the balancing machine to be sure it ran smoothly, put it back on the car, and the customer was ready to go.

Asset allocation balances the portfolio, so the assets run smoothly toward your goals. Sometimes people only need to make small adjustments, but often they need to make major changes in the distribution of assets.

Some people are so risk-averse that they want to keep all their money in cash, and they want to divide it up so they stay under the FDIC limits in each institution.

But this strategy only limits risk in the immediate future. Returns on cash accounts don’t even keep pace with inflation, so there is no opportunity for asset appreciation and they actually increase their long-term risk.

Dollar Cost Averaging with Farmer Joe

Many of us are tempted to wait for a windfall—winning the lottery or a big inheritance from Aunt Phoebe—before we even start to invest. Our hopes are high because we’ve heard stories of people who hit it big, but those stories are in the news because they’re so rare, not because they’re commonplace.

The best way to develop a substantial nest egg is to develop the discipline of putting money into a fund every month—no excuses. The market will go up or down, but our funds continue to grow slowly and steadily. I know people who began putting as little as $25 a month into an investment, and over time, they’ve accumulated a substantial amount of money.

When they were young, they had every reason to put off investing because they could easily use that $25 for dinner and a movie. But they were committed to save and invest, even if it was a small amount. When they got promotions and raises, they increased the amount they put away each month.

To explain the benefit of regular investing, I use the illustration of a farmer who invests each month in his favorite commodity: Cows.

Farmer Joe calls me and wants to invest $100 each month. When he begins, the market for cattle is near an all-time high. Cows are selling for $100 a head (which actually includes the entire cow, not just the head in case you’re watching Netflix while you’re reading this…).

He wonders if this is the right time to invest, but he needs more cattle.

• The first month, he can buy only one cow.

• In the second month, the price of cattle goes down to $50, so he buys two.

• The third month, the price goes to $25, so he buys four that month.

• And in the fourth month, the price of cattle plummets to a low: $20 each.

At that point he calls me and says, “Hey bucko, what have you gotten me into? Cattle are $20 a head! I bought all these cattle at high prices, and the bottom has dropped out of the market! I’m going to sell them all and cut my losses.”

I tell him confidently, “Farmer Joe, the market is very low right now. You were paying $100 a head four months ago.

You needed cattle, didn’t you? Has that changed? No? So why are you upset?

This is the best time to buy cattle, not sell. Hang in there.

You’re in great shape to benefit from this phase of the cycle.”

Farmer Joe bites his lip and decides to trust me.

• The next month, the price creeps up to $25 again. Farmer Joe buys four head.

• The next month, the price has risen to $50, so he buys two, and

• The next month, the price of cattle is back up to its high of $100, and he buys only one head.

At that point, Farmer Joe decides to sell. During those seven months, he bought nineteen cows for a total of $700. They’re worth $1900, yielding a net profit of $1200, and the price of cattle never rose above $100 a head.

Farmer Joe’s only regret was that he didn’t sell his tractor and buy more cattle when they were $20 each.

As I explain this story, I draw a chart for my clients. It looks something like the cow chart used in the beginning of this article (except that my cows never look that good).

Portfolio Rebalancing

Portfolio Rebalancing is Like Balancing a Tire, it’s the process of realigning the weightings of assets in your investment portfolio. Rebalancing involves periodically buying or selling securities to maintain an original or desired or risk level.

For example, say your original target was 25% small cap stocks, 25% large cap stocks, 25% international stocks and 25% bonds. If the small stocks performed well during the period, it could have increased the small cap stock weighting of the portfolio to 40%. At the same time, your bonds may have gone down so much that your bond allocation is now only 15%. So, you may then decide to sell some small cap stocks at this higher price and buy more bonds at this lower price to get your portfolio back to the original target allocation of 25/25/25/25

Portfolio rebalancing safeguards you from being overly exposed to undesirable risks — like way too much international stock in your portfolio.

These steps are taken to ensure the amount of risk involved is at your desired level. As stock performance can vary more dramatically than bonds, the percentage of assets associated with stocks will change with market conditions. Along with the performance variable, investors may adjust the overall risk within their portfolios to meet changing financial needs.

“Rebalancing,“ as a term, has connotations regarding an even distribution of assets; however, a 25/25/25/25 stock and bond split is not required. Instead, rebalancing a portfolio involves the reallocation of assets to a defined makeup. This applies whether the target allocation is 50/50, 70/30, 40/60, or 25/25/25/25 as in the example I used above.

While there is no required schedule for rebalancing your portfolio, most recommendations are to examine allocations at least once a year. It is possible to go without rebalancing your portfolio, however, regular rebalancing is one way to maximize returns AND minimize risk.

Portfolio Rebalancing gives you the opportunity to sell high and buy low, taking the gains from high-performing investments and reinvesting them in areas that have not yet experienced a lot of growth.

Calendar rebalancing is the most basic rebalancing approach. It can be done quarterly, annually, or every six months. This investment strategy simply involves analyzing your investment holdings within your portfolio at predetermined time intervals and adjusting to the original allocation at your desired frequency.

Monthly or quarterly assessments are typically preferred because weekly rebalancing would be overly expensive while a yearly approach would allow for too much portfolio drift.

The ideal frequency of rebalancing can be determined based on your time constraints, transaction costs, the options available through your custodian or 401k sponsor. A major advantage of calendar rebalancing over more responsive methods is that it is significantly less time consuming and costly for since it involves less trades and at pre-determined dates. The downside, however, is that it does not allow for rebalancing at other dates even if the market moves significantly. So, when the markets move significantly, you can take a more responsive approach to portfolio rebalancing.

Getting More Technical

Focus on the allowable percentage composition of an asset in your portfolio – this is known as a constant-mix strategy with bands or corridors. Every asset class, or individual security, is given a target weight and a corresponding tolerance range.

For example, an allocation strategy might include the requirement to hold 30% in emerging market equities, 30% in domestic blue chips and 40% in government bonds with a corridor of +/- 5% for each asset class. Basically, emerging market and domestic blue chip holdings can both fluctuate between 25% and 35%, while 35% to 45% of the portfolio must be allocated to government bonds.

When the weight of any one holding moves outside of the allowable band, the entire portfolio is rebalanced to reflect the initial target composition.

The most intensive rebalancing strategy commonly used is constant proportion portfolio insurance (CPPI) is a type of portfolio insurance in which the investor sets a floor on the dollar value of their portfolio, then structures asset allocation around that decision.

The asset classes in CPPI are stylized as a risky asset (usually equities or mutual funds) and a conservative asset of either cash, equivalents, or treasury bonds. The percentage allocated to each depends on a“cushion“ value, defined as the current portfolio value minus some floor value, and a multiplier coefficient.

The greater the multiplier number, the more aggressive the rebalancing strategy. The outcome of the CPPI strategy is somewhat similar to that of buying a synthetic call option that does not use actual option contracts. CPPI is sometimes referred to as a convex strategy, as opposed to a “concave strategy“ like constant-mix.

Key Takeaways

• Rebalancing is the act of adjusting your portfolio asset weights in order to restore target allocations or risk levels over time.

• There are several strategies for rebalancing such as calendar-based, corridor-based, or portfolio-insurance based.

• Calendar rebalancing is the least costly but is not responsive to market fluctuations, meanwhile a constant mix strategy is responsive but more costly to put to use.

Portfolio Rebalancing Retirement Accounts

One of the most common and important ways to rebalance are the allocations within your retirement accounts — remember The Perfect Investment? Hint, it starts with 401K. Asset Allocation impacts your overall performance and many investors prefer to invest more aggressively at younger ages and more conservatively as they approach retirement age. Often, the portfolio is at its most conservative as you prepare to draw out funds to supply retirement income.

Rebalancing for Diversification

Depending on market performance, investors may find a large number of current assets held within one area. For example, should the value of Tesla may increase by 25% while GM only gained 5%, a large amount of the value in the portfolio is tied to the Tesla stock. Should Tesla experience a sudden downturn, your portfolio will suffer higher losses by association. Rebalancing lets you redirect some of the funds currently held in Tesla to another investment (maybe Apple or Microsoft or McDonalds).

By keeping your funds spread out across multiple stocks — and multiple asset classes — a downturn in one will be partially offset by the performance of the others, which can help you maximize returns while minimizing risk over time.

4 Investment Strategies for Serious Investors

On YouTube

The story of Enron

The Enron Corporation is a Houston-based company that reached dramatic heights only to face a dizzying fall. The now infamous company and its historic collapse affected thousands of employees and shook Wall Street to its core.

At Enron‘s peak, its shares were worth $90.75; just prior to declaring bankruptcy on Dec. 2, 2001, they were trading at $0.26.1

To this day, many people wonder how such a powerful business, at the time one of the largest companies in the United States, disintegrated almost overnight.

Also difficult to understand is how its leadership managed to fool regulators for so long with fake holdings and off-the-books accounting. 

Key Takeaways

• Enron‘s leaders fooled regulators with fake holdings and off-the-books accounting practices.

• Enron used special purpose vehicles (SPVs), or special purposes entities (SPEs), to hide its mountains of debt and toxic assets from investors and creditors.

• The price of Enron‘s shares went from $90.75 at its peak to $0.26 at bankruptcy.

• The company paid its creditors more than $21.7 billion from 2004 to 2011.

Diversification Definition

Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time. ... One way to balance risk and reward in your investment portfolio is to diversify your assets.

Diversification: What It Is and How It Works

Diversification is the strategy of spreading out your money into different types of investments, which reduces risk while still allowing your money to grow. It’s one of the most basic principles of investing.

 

You’ve probably heard that old saying, “Don’t put all your eggs in one basket.” In other words, don’t put your money all in one investment, because if it fails, you’ll lose everything.

Diversification is an important part of long-term investing—think marathon, not sprint. Instead of chasing quick gains on single stocks, you’re taking a more balanced approach to building wealth.

Why Diversification Matters

The main reason to diversify is to reduce risk. You always need to remember that investing always involves risk. But by having a larger number of investments (aka diversification), you can put your money to work without risking your financial future if one of your investments goes bad.

Here’s a story to illustrate my point. Let’s say Mike and Sandi both make $100,000 a year in their home-based business. Mike’s money comes from four clients, but Sandi’s revenue comes from just one client. What would happen to Sandi’s income if the one client she works for goes bankrupt? Her only source of income is gone!

The same principle applies to your investment portfolio. If you’ve put your retirement savings into one stock, what happens if that company goes under? Boom! Your investments are gone. This is why I don’t recommend investing in single stocks—someone hiccups in Washington and the price plummets!

What is Asset Allocation

Diversification by Asset Class: When finance experts talk about diversification, they often recommend having various types of investments (called asset classes) in your portfolio.

Here are the most common asset classes:

• Mutual funds

• Single stocks

• Bonds

• Exchange-traded funds (ETFs)

• Index funds

• Real estate

If you’re a homeowner, then you can already consider yourself diversified! Owning a home is a great way to build equity outside of a traditional investment portfolio, and there are tons of great ways to invest in real estate.

I take a different approach than most financial experts. Instead of focusing on asset classes and encouraging you to buy single stocks and bonds, though, I always recommend people invest in mutual funds and diversify within those funds.

Here’s why mutual funds are better than other common asset classes:

Unlike single stocks, mutual funds are already naturally diversified—it’s like buying the variety pack of your favorite candy so you get a mix of everything.

Long-term government bonds have a history of yielding between 5–6%.1 Good mutual funds, on the other hand, will often double that rate of return.

Investments like index funds and ETFs try to mirror what’s happening in the market. But if you pick the right mutual funds, you can beat the market’s growth.

How To Diversify Your Investment Portfolio

The best way to diversify your portfolio is to invest in four different types of mutual funds: growth and income, growth, aggressive growth and international. These categories also correspond to their cap size (or how big the companies within that fund are).

Here are three steps for diversifying your mutual fund portfolio:

1. Choose your account.

The best way to actually get started is to crack open your 401(k) or 403(b) at work and see what mutual fund options you have. Workplace retirement plans like these have many advantages—they give you a tax break, they can be automated through your payroll deduction, and your employer most likely offers a match. If you don’t have access to a retirement account, then your best option is a Roth IRA through an investment group or broker. The word Roth gets me pumped, because it means that your money grows tax-free!

2. Diversify through cap sizes and international funds.

Now, once you open a 401(k) or Roth IRA, you’re not done yet. Your investment account is like the grocery bag, but you still need to pick your groceries—the actual funds where you’ll place your money. As you explore your account, you’ll see a list and description of your fund options. They all have different names (like Bank X Growth Fund or Group X International Fund).

An image explaining how to diversify your portfolio.

Here are the four types of mutual funds you should spread your investments into:

Growth and Income: These funds bundle stocks from large and established companies, such as Apple, Home Depot and Walmart. They’re also called large-cap funds because the companies are valued at $10 billion or more. The goal of investing in these funds is to earn you money without too much risk. These funds are the most predictable and are less prone to wild highs or lows.

Growth: These funds are made up of stocks from growing companies—or mid-cap companies valued in between $2 billion and $10 billion. They often earn more money than growth and income funds but less than aggressive growth funds.

Aggressive Growth: These funds have the highest risk but also the highest possible financial reward. They’re the wild child of funds, also referred to as “small cap” because they’re valued at less than $2 billion and are possibly still in the start-up phase. They’re made up of different stocks in companies that have high growth potential, but they’re also less established and could swing wildly in value.

International: These funds are made up of stocks from companies around the world and outside your home country. When the market takes a turn here in the States, you might not see the same downturn in foreign countries—which is why you want to have stock in them!

To diversify your portfolio, you need to spread your money evenly across these four kinds of funds. That way, if one type of fund isn’t doing well, the other three can balance it out. You never know which stocks will go up and which will go down, so diversifying your investments gives you the best protection against losses.

3. Meet with your investment pro to rebalance as needed.

The market is a living and breathing thing, so your funds’ values will change over time as they respond to how companies’ values rise and fall. That’s why you need to keep an ongoing conversation going with your investment pro and meet regularly to rebalance your portfolio.

Rebalancing is simply about making small adjustments to how you’re allocating money so that you maintain that 25% diversification in each type of fund we just mentioned. I personally meet once a quarter with my investment pro.

The key for successful investing is to be consistent. Ride out the downturns in the market. Stay focused for the long haul. And whatever you do, don’t withdraw from your 401(k) or Roth IRA early!

Think About it…

Why is Inflation is a Big Risk

Some investors get inflation… They understood inflation was a big risk to their future, but properly allocating their assets in the market would help them balance risk and return. When I showed them the math, they were stunned.

Here’s what I explained: If they kept that $100,000 in the money market (cash) account at .5% from age 35 to age 65, the account would be worth only $116,140. By investing their 401k into a diversified family of mutual funds with an expected return of 8% compounded annually, the amount would jump to $1,006,265!

• Kimberley and Ed almost fought each other to see who would sign the papers to move the funds.

• Asset allocation needs to factor in these elements:

• Your risk tolerance, which determines how aggressive or conservative your investments will be,

• The time horizon for achieving your stated goals, such as college education for a child in 2 years and retirement in 35 years, and

• The market dynamics of cash, bonds, equities, and real estate and their relationship to one another to maximize returns while minimizing risk.