Categories: investing, asset Allocation
“Don’t put all Your Eggs in one Basket.” Anonymous
This adage is CRUCIAL TO INVESTING. Plainly put, spread your risk around to keep your overall risk level lower.
There is an irony about investing-sometimes adding a high risk investment to a portfolio reduces overall risk.
I’m teaching an 8 week course in the MBA (Master of Business Administration) program at a local College. I thoroughly enjoy the information I am teaching as well as sharing it with the 15 students in the class. This knowledge is so important that each week, I’m going to take one of the basic concepts from the class and distill it for you. After reading each article you will gain a useable investing skill. This is the third class in the series, please check out MBA CLASS 1: Risk & Reward and MBA CLASS 2: Bonds, as well.
Before beginning any investment program, please follow these steps.
MAIN TOPIC: What is Asset Allocation?
Jack is afraid of the stock market, investing, and any movement in the value of his assets.
Jill understands that in order to receive greater wealth in the future, she must take some risks.
Here’s the Scenario: Jack and Jill each save $300.00/month for 40 years.
(Assumption: average annual long term returns for stocks 8.5%, bonds 5.0%, cash 3.0%; cash assets are certificates of deposits from a bank or a money market fund)
Look what happens with each of their finances:
Jill invested in a combination of 60% stock assets; 30% bond assets; 10% cash for a combined average return of 6.90%; Final account value =$770,077.00
Jack invested in only cash assets for an average return of 3.00%; Final account value =$278,512.00
$300 INVESTED MONTHLY FOR 40 YEARS
| Average annual return | Monthly contribution | Total amount invested | Value after 40 Years | |
| JILL | 6.90% | $300.00 | $144,000.00 | $770,077.00 |
| JACK | 3.00% | $300.00 | $144,000.00 | $278,512.00 |
Clearly, a mix of assets offers higher long term returns than cash alone. Jack and Jill are a perfect example of how investing the same amount of money yields widely different returns. Jill invested in a conservative asset allocation and ended up with $491,565.00 more than Jack.
But, wait a minute. What about the risk? Who had more risk or volatility? Well, Jack had NO VOLATILITY WHATSOEVER. The value of his investment never went above or below the interest payment + initial investment. On the other hand, Jill had to weather some ups and downs. There were even some years when her total investment value declined.
PRACTICAL APPLICATION: What to do?
Jack and Jill’s simple example illustrates the potential returns and risks of investing. In life as well as in investing, the greater the reward, the greater the risk. So, ask yourself, for future goals like retirement, college for your kids, a down payment on a home, are you willing to stomach a bit of risk in order to gain a larger return?
Jill didn’t spend a lot of time of effort on her investing; in fact, she chose these Index funds for her portfolio:
40% Vanguard Total Stock Market Index
20% Vanguard FTSE All-World ex-US Index
30% Vanguard Total Bond Market Index
10% Money market fund
Don’t make investing mysterious or complicated. Satisfactory returns can be gained with regular investing over the long term.
Caveat: This article is for information purposes only and may not be appropriate for your individual situation.
ACTION STEP:
Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it to keep all of your personal finance goals, thoughts, activities, and plans.
Educate yourself in investing by visiting Investopedia and Moneychimp.
Basic Terms:
Risk: Volatility or the price of your stocks and bonds going up and down.
Return: The amount of additional money you receive (or lose) on top of your original investment.
Financial asset: Stock, bond, cash etc. These assets can be combined in a myriad of ways and purchased in a mutual fund or exchange traded fund (ETF).
“You Like me, you really like me.” Sally Fields after winning an Academy Award.
OK, I didn’t even win an academy award, but I am honored to have my personal finance articles recommended by my colleagues. Here are some links to other sites featuring my articles & be sure to check out the other personal finance bloggers’ work as well:
How trading in a car every 2 years makes good financial sense @ Personal Finance by the Book
The Secret to Cutting Your Debt Immediately @ MoneySmartBlog, Invest it Wisely, & Personal Finance by the Book
How to Avoid Living Paycheck to Paycheck @ Tight-fisted Miser
Catfight of the Personal Finance Blogger Chicks; Bring it on @ Out of Debt Again & Len Penzo dot com
MBA Class 2: Investing & Portfolio Management-Bonds @ Invest it Wisely
For even more great Personal Finance Reading; visit these CARNIVALS I’ve participated in recently:
The Carnival of Financial Planning @ Money Smart Blog
Carnival of Money Stories 2 @ Green Panda Treehouse
I like how you mention Vanguard. Hopefully they can bring their mutual funds to Canada some day!
Thanks for the linkbacks
Nice presentation. Portfolio presented at the end is well done. Young people would do well to spend a few moments reading your blog.
Barb, this is such needed financial education. I think people really don’t realize the financial difference a “couple percent” can make in the end. You have just demonstrated nearly a $500,000 difference with a 3.9% spread. You even used a somewhat conservative average annual return for stocks of 8.5%. Just imagine what this would look like if they were investing $900 a month instead of $300 a month or if the annual gain was 10%.
@Kevin, @ DIY, @ Shawn- Thank you for continuing the conversation- it motivates me to continue promoting personal finance and investing literacy. Investing can be very straightforward, it does not need to be complicated! Best regards, Barb
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