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Dear Daily Crux reader, ------------------------------------------ The Daily Crux Sunday Interview The Daily Crux: Doc... many investors spend a lot of time and energy trying to pick the right stocks. But one's success as a stock picker actually plays a relatively small role when it comes to increasing wealth through investment... much smaller than the average investor realizes. Crux: This seems like simple common sense... to spread your risk around. Doc: I agree. But not doing it is an extremely common mistake people make. Crux: Could you walk us through what asset classes are out there... and what a sensible mix looks like? Doc: First off, you have one of my favorite assets in the world, which is cash. "Cash" simply means all the money you have in savings, checking accounts, certificates of deposit (CDs), and U.S. Treasury bills. Anything with less than one year to maturity should be considered cash. I like to keep plenty of cash on hand so I can be ready to buy bargains in case of a market collapse. Investors flush with cash are often able to get assets on the cheap after a collapse – they can swoop in and pick things up with cash quickly, and often at great prices. I generally recommend holding between 10% and 45% of your assets in cash, depending on your circumstances. In fact, one of the major tenets of good financial planning is to always have at least 12 months of living expenses in cash in case of disaster. If you haven't started saving yet, this is the No. 1 thing to start today. Next, you have conventional stocks. These are investments in individual businesses, or investments in broad baskets of stocks, like mutual funds and exchange-traded funds (ETFs). Stocks are a proven long-term builder of wealth, so I think almost everyone should own some. But keep in mind, stocks are typically more volatile than most other assets. Just like you should stay diversified overall with your assets, I think you should stay diversified in your stock portfolio. I once heard a well-known TV money show host ask callers: "Are you diversified?" According to him, owning five stocks in different sectors makes you diversified. This is simply not true. It is a dangerous notion. The famous economist Harry Markowitz modeled math, physics, and stock-picking to win a Nobel Prize for the work on diversification. The science showed you need around 12-18 stocks to be fully diversified. Holding and following that many stocks might seem daunting – it's really not. The problem is easily solved with a mutual fund that holds dozens of stocks, which of course makes you officially diversified. Crux: Let's discuss a few more asset categories. Eifrig: Next you have fixed income securities, with are generally called "notes" or "bonds." These are basically any instrument that pays out a regular stream of income over a fixed period of time. At the end, you also get your initial investment – which is called your "principal" – back. Depending on your age and tolerance for risk, bonds sit somewhere between boring and a godsend. The promise of interest payments and an almost certain return of capital at a certain fixed rate for a long period of time always lets me sleep well at night. Adding safe fixed-income bonds to your portfolio is a simple way to stabilize your investment returns over time. For people with enough capital, locking up extra money (more than 12 months of your expenses) in bonds is a simple way to generate more income that a savings account. Another asset class is real estate. Everyone knows what this is, so we don't need to spend much time covering this. If you can keep a portion of wealth in a paid-for home, and possibly some income-producing real estate like a rental property or a farm, it's a great diversifier. Crux: Do you consider precious metals, like gold and silver, an important piece of a sensible asset allocation? Eifrig: I do... But gold and silver, to me, are like insurance. Precious metals like gold and silver typically soar during times of economic turmoil, so I want to own some "just in case." But I'm different than the standard owner of gold and silver, who almost always believes the world is headed for hell in a hand basket. I'm a major optimist, but I'm also a realist. I believe in owning insurance. I believe in staying "hedged." For many years, my job at Wall Street bank Goldman Sachs was to develop and implement advanced hedging strategies for wealthy clients and corporations. The goal with these strategies was to protect jobs, wealth, and profits from unforeseen events. During those years, I learned a big difference between wealthy people and poor people. Wealthy people almost always own plenty of hedges and insurance. They consider what could happen in worst-case scenarios and take steps to protect themselves. Poor people tend to live with "blinders" on. So just like I wear my seat belt while driving, I own silver and gold – just in case. For most people, most of the time, keeping around 5% of your wealth in gold and silver provides that insurance. Crux: That's a great view of gold and silver. So... you've covered five broad categories... cash, stocks, bonds, real estate, and precious metals. Do you have any guidelines on how much of each asset folks should own? Eifrig: There's no way anyone can provide a "one size fits all" allocation. Everyone's financial situation is different. Asset allocation advice that will work for one person, can be worthless for another. But most of us have the same basic goals: Wealth preservation... picking up safe income... and safely growing our nest egg. We can all use some guidelines to help make the right individual choices. Keep in mind, what I'm about to say are just guidelines... If you're having a hard time finding great bargains in stocks and bonds, I think an allocation of 25%... even 50% in cash is a good idea.
This sounds crazy to some people, but if you can't find great investment bargains, there's nothing wrong with sitting in cash, earning a little interest, and being patient. If great bargains present themselves, like they did in early 2009, you can lower your cash balance and plow it into stocks and bonds. | ||||
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