Lubbock Christian University Novel Coronavirus COVID-19 update.Learn More
In the King James version of Proverbs 29:18, we are reminded that the people perish for lack of vision. The same might be said of investment portfolios.
Ample evidence suggests that the most important investment decision you will make is your asset allocation, or the division of your portfolio among the various categories of investments available to you. In the broadest terms, there are two classes of financial assets. The first is called “stocks” or “equities” and the basic idea is that you are one of the owners of the company, or group of companies, in which you invest. You are a residual owner, which simply means that you, like the other owners, get the financial leftovers after employees and creditors have been paid. Owners get only the leftovers. And owners get all the leftovers. If the company you own is doing poorly, you might get nothing. But if the company is doing very well, you will likely be left with a hefty share of the ample leftover profits. In
the long run, equity investments have higher risk (their prices often move up and down a good bit) and a higher expected return than the other broad investment category of “bonds” or “fixed income.”
As the name implies, “fixed income” securities (or “bonds”) give their owner a fixed, or set, rate of return. Owners of fixed income securities have loaned money to the company and are entitled to get their investment (principal) back at a fixed time, with a fixed rate of interest that is typically paid along the way. If the company is doing well enough to stay in business, fixed income holders will typically get paid the exact amount of principal and interest to which they are entitled at the exact time at which they are to receive it. And they get nothing more. If they agreed to receive a 2% interest rate, they will get exactly that, even if the stockholders in that same company are more than doubling their money every year.
There is no such thing as a free lunch. You can enjoy the safer road of fixed income, with a smaller expected return on your investment, or you can take on more risk with the hope of a bigger return. Anyone who says you can have lots of return with low risk is very likely to be wrong, and possibly selling a product you should avoid entirely.
The best strategy for most investors is to hold an asset allocation with both equities and fixed income securities. The classic split is 60% equities and 40% fixed income securities. Investors who are older, need their investment back sooner, or are more afraid of risk should tilt the classic split towards something more heavily weighted towards fixed income. Conversely, investors with longer time horizons and more tolerance for risk might tilt the split towards something more heavily weighted towards equities. No one size fits all.
Once you have formulated and implemented an appropriate asset allocation, it is generally best to stick to your plan until the change of something fundamental in your life, like the time you anticipate needing your investment back. If you frequently change your investment plan due to changes in market conditions, news you saw on social media, or a hot tip from your brother-in-law, your portfolio will likely suffer. It might even perish.
Few investors have the time, expertise, or money to build out a healthy asset allocation among individual stocks and bonds. That is where mutual funds and exchange traded funds can be your ally. We will discuss them next.
NOTE: If you missed Dr. Starr’s first installment in the investment series, you can read it here.
Dr. Brian Starr is the LCU Senior Vice President for Administration and Economics and Finance Professor in the LCU School of Business