If I were to ask you to take your life savings, drive to the casino, walk to the roulette wheel and put all of your money on black 17… would you do it? Probably not. But why? Because it’s risky. You’ve put all of your hope in that one thing. If it works, are you a genius? Umm…no. You were very lucky. Take your money and walk away. It’ll probably never happen again. The same is true for investing in stocks. Would you put all of your money in, say, Tesla? As desperately as I want a Model X and as much as I may like and respect Elon Musk - their founder and CEO, in case you were wondering - that would be foolish. In investment speak, that’s called a concentrated position. It’s the “black 17” of the investment world. And in my experience, most people understand that. So we take that risk and “diversify it away” by investing our hard-earned money into different stocks… say Microsoft, Apple, Wisconsin Energy, Ford… and the list goes on and on. So while the success of our investment strategy no longer rides on Elon Musk’s shoulders, we still have a problem. They’re all large (large cap) US Companies and they’re all stock. Different in some aspects, the same in others. Enter asset allocation.
If diversification is the process of having different kinds of similar things, then asset allocation is the process of having completely different things. Let’s unpack that. In the example above, we had lowered the risk of investing in only one company. Yet we were still left with the problem of having companies that were all still large and all located in the USA. That would be fine if those were always the best investments. But of course, there is no “always” in investing. Sometimes, medium-sized (mid cap) and small-sized (small cap) companies perform better. Sometimes, companies in growth mode (growth) or companies who have gone through difficulties (value) are better places to invest. Sometimes, companies in other developed countries (international) or companies in developing countries (emerging markets) offer better long-term investment opportunities. And let’s not forget about silver, oil, wheat and cotton (commodities) or apartments, office buildings and houses (real estate). And we haven’t even talked about bonds, which are essentially loans to federal, state and local governments, companies and even home owners. Each of these categories is a different “asset class”. They are all different and react differently to different economic conditions.
So what is an investor to do? Well, if you like the idea of putting everything on black 17, have at it. I wouldn’t recommend that, and you probably wouldn’t be a good fit for our firm. But if you’re like most people, you probably understand the value of not taking excessive risk. Which means you’ll have a portfolio with some of everything in it. We would call that a “blended portfolio”. Domestic and international stock, commodities, real estate, alternatives, and probably some bonds if you’re trying to limit volatility. But do you have equal amounts of everything? Probably not. That’s where the art comes in. Most portfolios have a large percentage in US stocks because the US economy is the most stable (less uncertainty/risk). And most believe Europe, India and East Asia have decent growth opportunities, too, so another – typically smaller - chunk of their portfolios is invested there. Even China and Africa have some growth prospects, so a portfolio may even include a small percentage invested there. If you’re closer to or in retirement or if volatility makes you uncomfortable, you’ll probably shift some of those stock investments into bonds which are typically less volatile and considered safer than stocks. Add on smaller parts of commodities, real estate, alternatives, and you’ve got yourself a portfolio!
I’d be remiss if I didn’t bring this back home to the importance of working with professionals. As I hope is obvious from the process I just outlined, the concepts are relatively easy to grasp. But executing all of this is a whole different ballgame. What stocks and bonds should you buy? What percentage of each should you have in your portfolio? Are the investments you’ve chosen performing as they should? Should you cut your losses and sell or recommit and double down? And are they right for your situation? Good topics for another blog post.
Michael J. Macco
Tesla, Ford and Wisconsin Energy are not closely followed by Raymond James Research. Raymond James makes a market in Apple and Microsoft.
Diversification and asset allocation do not ensure a profit or protect against a loss.
Any opinions are those of Michael Macco and not necessarily those of RJFS or Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Past performance may not be indicative of future results.