The recent government shutdown and threat of default shook financial markets and caused many consumers to reassess their financial plans. But has it fundamentally changed the way we should be investing our money?
Probably not, say the experts we consulted. But it certainly has raised new risks that all investors should take into account.
“The recent political issues have given rise to a major new issue that threatens to undermine even the best investment plans,” said Stephen Buser, professor of finance emeritus at Ohio State University. “The mere notion that the federal government might simply not make certain payments on its debt, even if it continues to have the means to do so, represents a major new risk for investors, not just in the U.S., but literally around the globe.”
The Fundamentals Haven’t Changed
Political uncertainty aside, our experts stress that the basic fundamentals for investing have not changed. Certain tried-and-true axioms still hold true, starting with the value of a dollar saved.
“For most individuals, in any environment, the key is to start saving now,” said David Hobson Myers, a professor of finance at Lehigh University. “Nothing else will get you to a well-funded retirement account than putting aside money today. The beauty of compounding (earning interest on interest or return on return) and building from today are the best beginnings.”
Diversification – basically the investor’s version of not putting all of your eggs in one basket – is another fundamental practice that the experts we consulted couldn’t say enough about.
“Diversification should be sought between and across asset classes,” said James DiLellio, assistant professor of decision sciences at Pepperdine University. “This strategy is largely independent of the current economic and political environment.”
Building on that idea, Seddik Meziani, a professor of finance at Montclair State University, says “research from both academics and practitioners alike keeps indicating that 70% of total return comes from proper diversification,” especially when “diversification is combined with good hedging tools.”
This all, of course, begs the question of what constitutes proper diversification.
A Closer Look at Diversification
While going all-in on a particular investment has the potential to produce the most significant returns, it can also lead to a world of pain if your bet doesn’t pan out or the particular segment of the economy you invest in begins to tank. Spreading out your investments, on the other hand, will reduce the chances of your entire portfolio suffering at the time and will lay the foundation for steady long-term gains.
There are a variety of ways that you can diversify your investments, including across:
- Asset Classes: Stocks (also known as equities), bonds, and cash accounts (e.g. money market funds) are considered the three primary asset classes for investors. Some people also include real estate and commodities in this bucket.
- Industry Segments: Companies are grouped into a variety of categories – from consumer staples and communication services to biotech and energy – that indicate the primary industry they operate in.
- Market Capitalization: Companies are also considered to be “large-cap,” “mid-cap,” or “small-cap” depending on the dollar value of their outstanding shares of stock.
- Investment Styles: Stocks are classified as being either “value” or “growth.” Value stocks tend to cost less than their earnings would suggest and pay regular dividends. Growth stocks offer greater potential for significant capital gains.
- Geographic Areas: The modern stock market enables us to invest in companies all across the world. These companies are broken down into regions, which include the U.S., Canada, Europe, Pacific (e.g. Japan and Australia), and Emerging Markets (e.g. China, India, and Brazil).
Spreading out your money in any or all of these ways will add a certain measure of security to your investment portfolio. The exact manner in which you do so ultimately depends on the money that you have available and your appetite for risk.
Choosing Investment Vehicles
At the end of the day, you’re probably more interested in getting specific investment recommendations than anything else. While the experts we consulted do mention a few as examples, one should never take action on an investment tip without doing a bit of good old-fashioned independent vetting.
That said, it’s also important to understand the types of investments that you can use to implement your newfound investing approach. So, what should we be putting our money in these days?
That’s a tough question to answer as it pertains to an imaginary “average consumer,” according to our experts, but there are a few rules of thumb that both minimize risk and maximize returns.
“In the traditional model for personal investment, which most financial economists endorse, an investor should first identify two basic investments,” Buser said. “The first basic investment would be a diversified portfolio of relatively safe assets. My personal choice would be a mutual fund that invests in U.S. Treasury securities with maturities between two and five years. However, many similar alternatives exist as well.”
The second basic type of investment, according to Buser, is a “broadly diversified portfolio of stocks, such as a mutual fund that seeks to match the S&P 500 Index.”
From there, you just need to figure out allocation – that is, how much to put toward stocks vs. bonds. While conceding that a balanced portfolio is still the best strategy for most investors, Charles McNally, chief portfolio strategist at American Independence Financial Services in New York, points out today’s balanced portfolio looks different from that of the past.
“For one thing, while investors still need a conservative allocation to balance their equities and other risky assets, the bond allocation would be smaller, more diversified across bond types and credit ratings, and/or shorter duration than the days when bond yields provided more of a livable yield,” he said.
Arvi recommends allocating your investments relatively evenly across “a few index funds: large cap equity (SP500), small cap equity, international blue chips, bond, real estate and commodity.”
It’s important to emphasize that this type of approach precludes the need to even concern yourself with specific stocks, bonds, etc. You can simply gain exposure to entire segments of the economy in one fell swoop with a mutual fund or Exchange Traded Fund (ETF).
“You can participate in the market via ETFs, thus minimizing stock-specific risk,” said Marco Avellaneda, a professor of mathematics at New York University who studies investment performance and pricing. “For example, if you think that the U.S. large caps – such as Apple, IBM, and Exxon-Mobile – will do well, buy DIA [SPDR Dow Jones Industrial Average ETF], not the stocks.”
The one thing you should pay close attention to, however, is how much you pay in fees and commissions to whatever broker you decide to use. And that is why ETFs are becoming so popular (more on them in a bit).
Exchange Traded Funds
Marcus Ingram, chair of the department of finance at the University of Tampa, is among the various other experts we consulted who recommends ETFs. ETFs, as alluded to earlier, are baskets of stocks assembled to replicate certain exchanges and provide exposure to particular segments of the economy or certain geographic areas, thereby reducing the burden on investors who have neither the time nor inclination to do the homework required to identify individual best-in-class stocks across different sectors of the economy.
ETFs are also attractive because they are cheaper than many other types of investments. Much of this has to do with the fact that most ETFs are not “actively managed,” which means the particular stocks that an ETF holds are based on the holdings of a particular index, rather than what a professional portfolio manager decides to buy and sell.
“You have a ton of great choices in the ETF and mutual fund universe to choose from so why not choose the ones that are cheapest?” Ingram asks. “I’m definitely a guy who believes that you shouldn’t have very high costs in your portfolio. You should use these fairly inexpensive products to get the exposure to those sectors that you want.”
However, like with any type of investment, there are risks associated with ETFs. These risks stem not only from what a given ETF may hold, but also from how it is operated.
“Ironically, ETFs, which can support the investment strategy of building a low cost portfolio, can also contribute to overtrading,” DiLellio said. “They can be traded throughout the day, may carry a trading commission, and in the case of more niche oriented funds, can have significant expense ratios.”
Brokerages list the costs associated with each fund, but Buser recommends Vanguard in particular as being a good source of low-cost options.
“Vanguard was a pioneer in terms of developing these products for retail customers,” he said. “Hence, as a matter of routine, I often suggest that new investors at least check out the base investments offered by Vanguard and make a note of the exceptional modest servicing fees that Vanguard is able to charge when compared to many of its competitors.”
Your Investment Timeline
How do you see your next five years playing out? What about the next 25 or even 50 years? You need to ask yourself such questions when planning an investment strategy because, as mentioned earlier, your timeline should dictate your appetite for risk – at least to a certain extent.
“The extent of risk tolerance can depend on a variety of factors including a general perception about the level of risk to financial assets as well as the current wealth of an investor in relation to long-term goals,” Buser said, adding that people can think of it like a football game.
“To use a football analogy, if a team is ahead by a comfortable margin in the 4th quarter, then relying more on safe running plays and less on risky passing plays might well be optimal,” he said. “On the other hand, if a long term investment program falls significantly behind its projected path, then even an otherwise conservative investor might be inclined to increase the allocation to the stock portfolio in much the same way that a football team that falls behind in the 4th quarter of a game is more inclined to increase its rate of passing.”
That, in short, means people in their 30s and 40s can take a longer view and perhaps take on more risk, while those nearing retirement have to play it safer. Stocks are generally considered to be riskier than bonds, so younger people should therefore favor stocks disproportionately before building up their bond and cash positions as they approach major life events such as paying for higher education and, ultimately, retirement.
“To me retirement is a very different issue than, say, saving up to make a large donation or purchase,” Ingram said. “If you know that down the road you’re going to buy a retirement home and it’s going to be $200,000, a onetime hit, then I think you should make a multi-year plan to start moving money into cash so that you have more like a dollar cost averaging approach.”
However, Ingram also cautions against overdoing things as you approach the standard retirement age, simply becasuse people are living increasingly longer.
“You don’t want to start switching to a bond portfolio where you give up your growth because I’d like to think we’re all going to live to be 100,” he said. “So I just think when you retire, you need to structure your portfolio so that it continues to have a great deal of growth potential. Maybe just shift to a slightly larger bond component and to more dividend paying stocks. But I would still say even if you’re 65 and you’re now living off your retirement, you’d want to be more than 50% in equities.”
Pitfalls: Timing the Market, Overtrading & More
For investors, there are plenty of pitfalls. Arvi says the general public has low levels of financial literacy with a herd mentality, which can often lead to big losses.
“Most people buy high when the markets are frothy and sell when markets crash,” he said. “A good example is in 2008 when many people saw their retirement portfolios being halved, panicked and sold out. Had they stayed invested, not only would they have recovered everything they thought they lost but also earned dividends during five year period. Be a value investor and invest for the long term and do not worry about day-to-day fluctuations in the market.”
McNally echoes those sentiments, saying that “people make the same mistakes today as they have always made.” They remember the most recent crisis for too long and miss the best performance by staying conservatively positioned well past the danger point, and then they shift to a riskier balance once the macro picture is perfect.”
At the end of the day, it seems to all come down to having a conservative, well-thought-out plan that you execute with consistency.
“The biggest mistakes continue to be chasing returns and not having a good exit strategy,” Hobson said. “When you buy an investment know what your objectives are and what are the indicators that will get you to sell.”
Still hungry for investment advice? You can find more experts’ insights below.
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- Investment Strategy
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