Investing for the long run can be a tricky business. The data supports owning stocks, yet the volatility of the stock market can lead to emotional trades and untimely decisions.
So how can an ordinary investor balance out the risk?
The answer is asset allocation, a fancy term which just means owning a lot of different investments. That means owning stocks but not just U.S. stocks. It means owning other investments, too.
To understand asset allocation better, let’s break down a few of the ways that we can diversify our investments in order to lower risk.
Use index funds
First and foremost, you can lower your risk by owning a lot of different stocks, rather than attempting to choose from a small group of currently popular companies.
Did you know, for instance, that lowly Domino’s Pizza outperformed Google, Facebook, Amazon and Apple over the last 10 years. It’s true.
That doesn’t mean you should put it all on pizza stock. Rather, it suggests that guessing which stocks will “win” in any given period of time is pointless.
Buying an index fund resolves this problem: You get all of the performance of the market at a low cost.
Own foreign stocks
We tend to prefer stocks issued in our own country and shun stocks issued abroad. Funny thing is, people in foreign countries do the same thing. Indians prefer Indian stocks, Brazilians prefer Brazilian stocks.
Somebody must have this wrong, right? Owning a percentage of foreign shares provides diversification and better return than singling out one part of the world for no other reason than “I live here.”
One big reason stock ownership pays off is that dividends can be reinvested automatically. A lot of the stock you own, even in index funds, spins off cash every three months.
It adds up to about 2% to 3% of your total return, money which if set to reinvest adds to your long-term return by increasing your position in stocks with no effort.
Even the most thoughtful portfolio can get out of whack. The stock market might run higher for several years in a bull market, leading to a bigger stock holding than you might desire.
Rebalancing is just taking some of those gains and using the money to buy bonds, real estate or other investments that counterbalance stock holdings. If stocks fall (which will happen, eventually), your investments in non-stock positions help you absorb the shock.
Reduce exposure slowly
As you get closer to retirement the one thing for certain is that you won’t need nearly as much of the upside of stocks and will grow wary of the potential for declines.
The solution is to move slowly, over years, to a greater concentration of fixed-income investments, such as bonds, or holding more cash in interest-bearing bank accounts.
Be careful not to move too fast, however. Americans are living longer and longer, and much of our big spending on healthcare comes at the end of life.
If your portfolio balance is lower than you would like today, stocks represent your best chance to grow that money for the eventual someday you need it.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.