With your personal finances, don’t put all your eggs in one basket. And the opposite is also true; don’t spread them out amongst too many.
The idea is to find the proper amount of diversification that will help get you where you want to go, without too much worrying and hand wringing.
So what is diversification? Wikipedia tells us:
In finance, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets.
It’s prudent to find the right mix of investments for our personal situations. We don’t want to have all of our money in highly speculative investments, and we don’t want all of it to be in cash. A big part of successfully finding the sweet spot is to be honest with ourselves about our motivations. Put simply, humans are motivated by greed and safety. Unchecked, greed will lead us to being too aggressive, and safety will cause us to be too conservative.
For over 20 years as a financial advisor, I’ve been helping people find their “just right.” I’m honored to be named to Investopedia’s list of the top 100 financial advisors many years running.
Here’s what we’ll cover:
- The problem with extremes
- The case for boring
- The case for less boring
- Understanding active and passive investing
- Understanding risk tolerance and asset allocation
- How much?
Let’s get started.
The problem with extremes
Hot = Aggressive, Cold = Conservative
Remember Goldilocks? It’s a wonderful children’s story that teaches us that “just right” is superior to too hot or too cold. With investing, hot = aggressive, and cold = conservative.
If we’re too aggressive in our investing, we risk losing our money through speculation. When we’re too conservative, we can miss out on growth and compounding. The trick is to investigate the objectives for our investments, our risk tolerance, and to make our allocation decisions based on those two important factors.
The case for boring
“Rule number one: never lose money. Rule number two: never forget rule number one.” – Warren Buffett
When we lose money in the stock market, it takes a lot more to recover and get back to even than we realize:
- With a loss of 10%, one needs a gain of about 11% to recover
- With a loss of 20%, one needs a gain of 25% to recover
- With a loss of 30%, one needs a gain of about 43% to recover
- With a loss of 40%, one needs a gain of about 67% to recover
- With a loss of 50%, one needs a gain of 100% to recover
This is why Warren Buffett vehemently stresses the avoidance of losing money.
I bet you’ve already got a lot of excitement in your life. Maybe you’ve got kids who keep you on your toes, or a hobby that keeps things interesting. If you don’t, I encourage you to find something to scratch that itch.
80 to 90% of day traders lose money. Don’t make investing your outlet for excitement. That’s not what it’s supposed to be. For the vast majority of investors, the purpose of investing is to achieve your goals and objectives.
Now, I’m not discouraging you from learning about the stock market and actively trading. If that’s something you want to do, do it. But even after you spend the resources to learn how to be a trader, the majority of your investments should be in well-diversified vehicles like mutual funds and ETFs.
Planning and investing based on an 8% rate of return will get you where you want to go over the long term. Saving $500 a month for 30 years at 8% will get you $708,817. While I appreciate there aren’t too many investments that go up in value every year, I share that to illustrate the value in taking a “slow and steady wins the race” approach to your investing.
Consistent investment in high-quality vehicles is a recipe for long-term success.
The case for less boring
The fear of loss is said to be twice as powerful as the desire for gain. That fear can lead people to be overly conservative with their investing. The problem with that approach is that it limits our participation in growth through compound interest.
Earlier I shared how saving $500 a month for 30 years at 8% will get you $708,817. Not surprisingly, saving $500 a month for 30 years at 4% will get you $343,760; a little under half the amount. If you’re not sure if you’re current approach to investing is too conservative, ask yourself this, “If my investments perform as I expect them to, what will the result be?” If that result comes up short of your long-term saving and investing objectives, it’s probably wise to rethink your approach.
As with being too aggressive, I don’t want you to overcorrect and totally change your approach. Rather, spend some additional time thinking about where you want to end up (goals and objectives) and make sure what your approach to investing will get you there.
Understanding active and passive investing
Investopedia provides a robust overview of the differences between active and passive investing. Briefly, active investing seeks to beat the stock market. Passive investing seeks to get the same returns as the stock market.
With active investing, you can think about a traditional portfolio manager who is constantly evaluating, buying and selling stocks. Passive investing commonly involves buying a low-cost, well-diversified investment like an S&P 500 mutual fund or ETF.
Historically, a passive approach has outperformed an active approach. This is not to say there aren’t people who beat the stock market; there are. There just aren’t very many of them.
I like to think about it like the NFL. Do people play in the NFL? Yes. Is it possible for me to play in the NFL? No. This is the case for a variety of reasons (age, physical ability, willingness to commit), and it’s also true for finding success as an active investor. If you’re willing to commit to investing the resources to learn how to invest, and to then apply them, you can probably find success. If you’re not, taking a passive approach is the better decision.
Understanding risk tolerance and asset allocation
Understanding your risk tolerance is important for a variety of reasons. In order to achieve your financial goals, you need to be invested it the right things. And being invested in the wrong things can cause unnecessary stress and anxiety.
If you’re not sure what yours is, you can access our Risk Profile for free. It will be a good starting point for helping you understand what kind of investor you are. Once you have that baseline, there’s value in exploring why you feel the way you feel about investing.
Many of our beliefs about money were developed when we were kids. Some we got from DNA, but most from our experiences. How did your parents think or talk about investing? We’re they conservative, aggressive, or somewhere in the middle?
Over time and with more life experiences, our risk tolerance can change. Just because you think and feel a certain way about it today doesn’t mean you will in the future.
Risk tolerance informs our asset allocation, or mix of investments. Your asset allocation is comprised of asset classes like cash, stocks, bonds, and real estate. When thinking about yours, time horizon (as well as risk tolerance) must play an important role. Think about when you’ll need the money you’re saving and investing.
Earlier, I mentioned how the vast majority of your investing should be in well-diversified vehicles. Specifically, I advocate for 80 to 90%. Here’s another approach to consider; once you’re on track to meet/exceed your financial goals and objectives, and you want to take on more concentrated risk, go for it. At that point, you’ve positioned yourself for success. Think of it like writing yourself a permission slip.
Don’t put all your eggs in one basket. A diversified approach to your investment might be boring, but you’ve already got enough excitement in your life. Your investing doesn’t’ need to provide you with any more.
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