It is also important, being that we cannot presume the future, to practice diversification and dynamic asset allocation. Solomon said about diversification in investing, “Give a portion to seven, and also to eight.” Being that he was a multi-billionaire, far wealthier, within the context of his time, than Gates or anyone in our time; he might have known something about wealth building. In other words, “Set up seven tracks of wealth building and eight tracks would be even better.” You might take one track based on the best possible information and it just flat will not work despite your best research.
I use stories of cockatiel and orangutan ranches to illustrate the power of compounding in previous posts in this blog. What I do not show you is that you could start with 12 animals and grow to vast numbers, but the result could gyrate wildly up and down in particular years. There might be years of unbelievable growth and years of devastating decline. What if a “year of devastating decline” happens just as you are preparing to retire? You could even start with 12 units and end with 10 units or none at the end of the 70 years. The whole thing can go wrong no matter how thoroughly you investigate before you invest or how careful you are in monitoring the investment. This is why the sly guys diversify.
If you start with an IRA when you are young, you might decide to put $1000, at perhaps $20 a week, in a mutual fund and another $1000, at $20 a week, in another mutual fund. You might do this for several years or all the way through, depending on what you decide. However you do it, this represents two investment tracks. Then later you set up another track, perhaps even in something other than a mutual fund, and then another and another and so on. You protect yourself by breaking your investing up into parts.
Consider the following example, which illustrates the wisdom and power of diversification. There are two investors that we will give the very imaginative designations of “A” and “B.” A and B each has $100,000 to invest.
A is archly conservative and finds an investment that is 100% guaranteed safe which will pay a 6% return each year.
A puts the entire $100,000 in this one investment and lets it compound annually for 30 years at a safe 6% per year.
B breaks her $100,000 into 5 parts of $20,000 each. B is more adventurous and puts each $20,000 in a higher risk investment that also has a higher chance of a larger return.
(I wonder if this lady is the Aunt B on the Andy Griffith Show. Oh, that’s right; she is probably Aunt Bee, not B. Sorry, my bad.)
The first $20,000 in B’s first investment is completely lost. She not only does not make any return, but also loses the original $20,000.
The second $20,000 in B’s second investment has a return of 0%. She makes nothing, but at least still has the original $20,000 at the end of the 30 years.
B’s third $20,000 investment has a return of just 5% that compounds annually for 30 years.
B’s fourth $20,000 investment has a return of 10% that compounds annually for 30 years.
B’s fifth $20,000 investment has a return of 12% that compounds annually for 30 years.
At the end of the 30 years, A has $574,000 and B has $1,054,000.
Notice that 3/5 of B’s investments did more poorly than A’s one investment did, yet B has more money. Behold what diversification can do for you!
Asset allocation has to do with the formula you use to break your investing up into parts. You have a risk tolerance that fits your outlook and personality. The way this is normally laid out would go something like this.
If you are an aggressive risk-taker, you might go maybe 70% in growth oriented stock mutual funds, 20% in bond mutual funds, and perhaps 10% in money market.
If you are more conservative, you might put 50% in stock mutual funds, 30% in bond mutual funds, and 20% in money market funds.
If you are archly conservative, you might put 30% in stock mutual funds, 40% in bond mutual funds, and 30% in money market funds. It is perfectly alright to be careful, but you have to realize that “careful” generally requires a commitment to larger contributions over time because “careful” tends to get the lower rates of return in the long run.
There are also, of course, many other investment options beyond mutual funds. There are folks in the financial advising community who are increasingly touting the importance of thinking outside the box, of getting outside that poor maligned box, to invest in alternatives such as precious metals, life settlement pools, real estate, and other things. There are even those who argue that the old “build it with a 401(k) and an IRA” days are over and we just don’t get it yet.
(I actually found the literal box that everyone is trying to think out of and I made an authentic, 100% genuine replica of it that I sell for 25.95 plus 5.95 shipping and handling. Order by sending a check or money order in the amount of $31.90 to: Out-Of-The-Box Box, 13236 Lexington Lane, Balch Springs, Texas 75180. Please allow 8 weeks for delivery. So if you want to think outside the box and invest in the out-of-the-box box, let me know and I will cut you in on this exciting new “out-of-the-box” investment opportunity.)
Dynamic asset allocation means that the percentages assigned change with changing trends, the economic climate, the recent history of the Prime Rate, and other factors. A financial planner would help you understand the factors and trends at work and, in consideration of your basic risk tolerance, help you decide what percentages to assign to each area. With dynamic asset allocation, these percentages change over time as factors and trends change. If a financial planner does not practice dynamic asset allocation, then they are probably really just practicing “buy and hold”, even if they call it something else. “Buy and hold” refers to investing in something and just riding it throughout the decades no matter what happens. The decision is yours. If you wanted to have one investment track (or more than one) of “buy and hold”, that would be your choice.
One other factor in this is your age. When you are young, you can afford to be aggressive. Generally speaking, the more aggressive you are in your investment selection, the more money it will make over the long run. The tradeoff is volatility (the drastic short term up and down-ness of it). In the short term, there will be periods when the aggressive-oriented investment will go down, but it will tend to increase over the long run. These are the funds and stocks that have the giant gains over the decades, but also have scary plunges in particular years.
When you are young, you can take these hits because you have plenty of time to recover. When you get near retirement age, you cannot afford to drop one third or one half of your portfolio value overnight, because your portfolio (all the things you invest in) might not recover in time for you to retire. So, when you are older, you tend to have a more conservative asset allocation. A good financial planner or investment advisor can help you understand this and help you decide on an appropriate investment mix.
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