The Value Of Investment Diversification

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.  Diversification is one of the most important things you can do to reduce the risk in your portfolio.  If you have all of your money in one stock in could go up 100% or lose 100% .  If you owned Enron or Kmart you could have lost all of your money.  Risk can be measured mathematically and it is called volatility.  This is an image of a stock with high volatility.

Below is a picture of stock with low volatility.  In this example, the stock went down.  Volatility is not related to the direction of the stock price but to the rate of change (up and down) in the price.  More movement equals more volatility which is said to be more risk.

If you own only one stock you could get a big surprise if the company does not make its expected revenue numbers.  If you own more stocks, the effect of one stock becomes much smaller.  The idea is that while some stock go up - some go down but on average they go up with much less volatility. 

From Wikipedia...

In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3290 securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each included asset, for various values of n. Their results are summarized in the following table. It can be seen that most of the gains from diversification come for n≤30.

Number of Stocks in Portfolio	Average Standard Deviation of Annual Portfolio Returns	Ratio of Portfolio Standard Deviation to Standard Deviation of a Single Stock
1	49.24%	1.00
2	37.36	0.76
4	29.69	0.60
6	26.64	0.54
8	24.98	0.51
10	23.93	0.49
20	21.68	0.44
30	20.87	0.42
40	20.46	0.42
50	20.20	0.41
400	19.29	0.39
500	19.27	0.39
1000	19.21	0.39

The Important thing to see is that 1 stock has a volatility of  100% and 30 stocks have a volatility of 42% (of one stock).  With more stocks you dramatically decrease the volatility / risk.

Most investors do not have the funds to buy stock in 30 different companies.  Just $5,000 per company would take $150,000 plus all of the fees involved to make the trades.  What you can do, is buy a diversified stock mutual fund or even better - an index fund.

I Only Have $10,000 – Where Do I Invest It?

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.  For the last several weeks we have been working on answers to some questions asked by a reader named Jemand.  This will be the last part of that series.  If you have any questions about investments, please let me know.

I need to start saving for retirement (I’m in grad school) but I don’t really know how to even start or how to even go about *buying* any kind of stock, much less, kinds that make particular sense for me. Also, I have less than 10,000 I can invest right now, so it feels to me that paying a financial advisor would take out way to large a chunk of what I’d be making.

Most financial advisors get paid a small (or not so small) percentage on the amount you invest.  So, with a smaller account your fee will be smaller.  For more on investment advisors - read this post.  The problem you may have is that some advisors will not want to work with you if you "only" have $10,000.

So... What to do with the $10,000.  If you are going to do it by yourself you will need to think about several things.  How old are you?  What is the money for?  How much risk can you take?  How long will the money be invested?  Will you add more or will you start to take money out?  Do you have life insurance?  All of this things and more could change where you put the money.  This is one of the reasons that it is impossible to give investment advice to everyone at once.  The advice needs to be based on that person.

Keep in mind this is not actual investment advice for any person and you should check with your advisor before doing anything.  In our example the person investing has $10,000 and is a 25 year old female with no spouse or kids.  This person has a good job with a reliable income stream and does not need this money until they retire. 

One of the most important factors in your long term investment results is expenses.  To keep expenses low, I would suggest an index fund.  Vanguard has the most index funds with the lowest expenses.  For starters I would suggest the Total Stock Market Index Fund.

Created in 1992, Vanguard Total Stock Market Index Fund is designed to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks. The fund’s key attributes are its low costs, broad diversification, and the potential for tax efficiency. Investors looking for a low-cost way to gain broad exposure to the U.S. stock market who are willing to accept the volatility that comes with stock market investing may wish to consider this fund as either a core equity holding or your only domestic stock fund.

When more money is saved consideration could be given to other types of investments.

How Do I Get A Financial Advisor?

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.  A couple of weeks ago a reader named Jemand asked some really good questions.  Today I am going to address another part of Jemand’s comment. 

How do I get a financial advisor? How much do I have to pay her/him? How much money do I need to plan to invest to make it worth it? Can I talk to someone at my union? Etc.

There are a couple of ways you can get help with your investments and I will cover some of them below.  Before I do that I want to talk about the, "How much money do I need..." comment.  You will have more options with a large about of money but you can start with as little as a few hundred bucks in a savings account and add money to it every week or month.  The sooner you start saving the longer you will be able to watch the money grow.  The danger here is getting into a bad investment.  I do strongly suggest that you have a basic understanding of investments before you go past a savings account.  There are mutual funds that you can invest in with very little money - around $1,000.  With $3,000 - $5,000 you get into most funds.

In reference to asking the union or your company for advise - bad idea.  Often the people you ask for advice will know less then you or worse they may seem like the know things but they have it all wrong.  If they send you to an expert in will usually be a sales person that gets paid a commission to sell products to you.  In this case there may be a conflict of interest on the part of your advisor.  It is not always bad - but how will you know?  This leads me to the discussion of how to get an advisor.

The phrase "Financial Advisor" is used by a lot of different people so it can be tough to figure out.  The vast majority of people in the investment advise world get paid a commission to sell things to you.  If you have $100,000 and buy what they suggest they may make 4%, 6% or even 10%.  You don't write them a check and if you don't ask you may never know how much they get paid.  However, I can assure you they do not work for free.  The big risk can come when the "advisor" is in the position of making $6,000 (6% of your $100,000) or $10,000.  What would you do?  Would you do the right thing?  Every Time?  This can be very tempting for the advisor and like most humans they can probably come up with some good post hock rationalization to relieve the cognitive dissonance for the fact that you got and investment that may not be the best option.

An example I like to use.... If you go to the Ford dealership and ask a salesman what is better Ford or Chevy?  What do you think he/she will say?  They will tell you Ford!  They may be right but if there was a Chevy that better fit your needs - would they give you all the details?

What you should look for is a Fee-Only financial advisor that gets paid by you.  Like the auto example above, this would be a person that could help you look at all types of cars (or investments) and help you get the best one.  People work for those that pay them and a Fee-Only advisor should be able to state that they get paid from no other source.    You want your advisor to work for you not some big investment company.  Fee-Only financial advisors may charge anywhere from 2% per year for small accounts to .5% for larger accounts ($500,000+).  This is something that you would need to discuss with the advisor. 

My experience has shown that most people do better with and advisor, even if the advisor is paid a commission.  So, I'm not saying that a commissioned sales person is bad, I just think you can do better with a Fee-Only advisor.

Investing - Where Do I Start?

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.    Please consult with your financial advisor (or Polaris Financial Planning) before taking any action.  Last Monday I did a post about Index funds and a reader named Jemand asked some really good questions.  Today I am going to address the first part of Jemand's comment.

Alright, so I know I shouldn’t make investment advice on the basis of a blog. But I don’t even know where to start!

Great Comment!  Where does one start?

I regularly suggest that people read up on investments.  One easy way to do this is to pick up a few copies of a magazine like "Money" or "Kiplinger's".  You can just get one or two at a book store or read them for free at your library.  The magazines usually have short pieces that are written for the novice reader.  Read them and become familiar with the terms and some basics on how the markets work.  You will not become an expert over night but after you read a few you will understand some basics which may prevent you from getting ripped off.  The one warning I will give is that you do NOT take any of the specific advice given in a magazine.  In a single issue you can find a story on buying for the long term and another on the hottest stock over the last 6 months.  If you are new - you will have no way to know which ideas are good for you and you can easily start down the wrong path.  A few extra months of education should pay big long term dividends.

I always remind people that one of the best ways to make money in the long run is to not lose money in the short run.

The next step if you want to take it - read some good books.  I can tell you about one of my favorites.  "Common Sense on Mutual Funds" by John C Bogle.  This is a classic book and the original version is still full of relevant information (shown on the left).  However it has been updated and is even better ("revised" version is on the right).  It has a lot of math and statistics so it may scare off some readers but, it is not that bad!  It is one of the most important investment books I have ever read.

What Is An Index Fund?

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action. A nice place to learn about investment terms is Investopedia.  Here is there definition of an Index Fund.

A type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.

Good... but I'm not sure what they mean when they say, "... is said to provide...".  An Index fund actually does these things.  Unless, you get a very specific type of index fund that focuses on a small market segment.  Let's look at an S&P 500 Index Fund.

Broad Market Exposure

This index fund invests in 500 stocks.  500 different US companies.  This is very broad exposure.  If one of those 500 stocks goes to $0.00 in just one day it will only bring down your portfolio 0.2%.  The whole market can move more than that in a day.  You will never even notice the loss.  This also works on the upside, if one of those 500 stocks double it will only give you a 0.2% bump.  This broad market exposure effectively reduces your volatility.

Low Operating Expenses

If you are in a 401(k) or a 403(b) you may see index funds with expense ratios as low as 0.5% to 0.8%.  The average mutual fund has an expense ratio of around 1.6%.  The extra 1% savings could make a big difference over time.  If you go to Vanguard, you can get index funds with expense ratios lower than 0.2%.

Low Portfolio Turnover

If you are in a taxable account this can really pull down your performance.  If a stock is held for more than a year than you will only pay capital gains of 15%.  However, a stock sold in less than a year can be taxed as high as 35% - Ouch!  An S&P index fund may change only 2-4 % of the funds in a given year.  A managed fund can change 100% or more (sell twice) in one year.  Even if your managed fund beats the market you may get killed on taxes.

One of my investment rules.... By Index Funds whenever you can!