Thursday, July 12, 2007

Maximizing Your Investment Returns is a Balancing Act

Today the stock market had the largest single day gain in four years. Meanwhile, the real estate market continues to languish. It is funny how things have flip flopped in just two short years. I know I have talked about this in the past, but I thought it would be fitting to revisit the importance of balancing your investments through asset allocation.

Here are the major investment asset categories (listed from less risky to riskiest):

  • Cash/Money Market- This is the least risky because deposits up to $200k are insured by the Federal government. It also provides the lowest return on your investment (supposedly). Pundits tell us you should have at least 3 months of expenses in cash/money market accounts. In today's environment, I recommend a different strategy. You should have 6 months of expenses in cash. The best place to park your money is either in CDs (certificate of deposits) or in a high interest savings/checking account. Check out these aforementioned links on my past posts.
  • Bonds- Unless you are on the verge of retiring, I cannot really recommend bonds. Some people have been successful in bond investment in the past, but the slightly greater rate of return on bonds these days is not worth the extra risk. If you still want some exposure to bonds (I recommend no more than 10% of your total portfolio if you have to have them), check out high yield bonds or municipal bonds (for strategic tax planning purposes).
  • Stocks- This asset class offers so many vehicles for investing and includes everything from mutual funds to index funds to individual stocks to international stocks. Since this is almost one of the most popular investments, I think it is best to talk about the different kids of stock investments separately.
  • Mutual Funds- I don't know why people invest in mutual funds anymore. Granted there are some really great fund companies (Dodge & Cox is my favorite), but the high fees, inability to manage tax consequences and the emergence of index & electronically traded funds have made mutual funds almost obsolete. Less than 10% of the stocks I own are in mutual funds.
  • Index Funds/Electronically Traded Funds- These are my favorite. Basically, these are baskets of individual stocks that trade collectively as an individual stock. Better yet, whereas in the beginning the index funds were limited to the SPDRs (tracks the S&P 500) and the QQQ (tracking the Nasdaq 100), today there are hundreds of funds that follow everything from oil industry companies to ecologically friendly companies. Here is a list of the top performing index funds. Since these funds trade just like a share of stock, you can control when you sell it to manage your taxes better. Plus, many of the funds are no or low fee. At least 50% of the stocks I own are index funds.
  • Individual Stocks- These are stocks of your favorite companies. I am a firm believer in buying stocks in companies that you like or purchase from. This methodology is used by Warren Buffett (and he is a pretty savvy investor). When buying an individual stock, I usually look for one "on sale". In other words, I buy a stock on a dip (as long as the drop in price isn't related to a fundamental business problem). This may be a terrible example, but I love the organic food store Whole Foods Market (ticker: WFMI). Today, it was released that the company's CEO made unfavorable comments about a rival store (Wild Oats) on a chat room trying to drive down the price of Wild Oats stock just months before Whole Foods made a bid to buy the company. Today, the stock was down 2% because the CEO was stupid. I decided to buy more of the stock because his comments shouldn't affect the fact that America's desire for organic food is growing. Try to limit 20% of your stock portfolio to individual stocks since they are inherently more risky than a basket of stocks (like mutual and index funds offer). Finally, look for individual stocks that pay great dividends. Companies like Altria, Bank of America and others pay over 4% dividends recently. This is better than most money market accounts and offer a pretty good rate of return by itself (the stock's appreciation at this point is just gravy). Better yet, there is an index fund with the ticker DVY that holds the stocks of companies paying the highest dividends.
  • International Stocks- I wanted to give this class of stocks its own section because it is one of my favorites and I have dedicated 20% of my stock portfolio to these stocks. I buy mostly index funds for international stocks (EEM for emerging markets, EEB for Brazil, Russia, China & India, but there are a load of others). The returns on international stocks have been nothing short of spectacular the past few years. I sincerely believe as we continue to expand the global marketplace that many of the best companies (and investments) will come from overseas. Even Warren Buffett has gone overseas to invest in an Israeli company. There will always be turmoil and unstable governments that make this a very risky investment, but it is this inherent risk that makes the return that much better.
  • Real Estate- Everybody who owns real estate has a portion of their wealth invested in the asset class of real estate. You can also invest in REITs (Real Estate Investment Trusts) which allow you to own a stock like investment whose value is tied to a portfolio of real estate investments (apartment complexes, skyscrapers, hotels, etc.). Recently the value of REITS has declined with the overall market. However, I still recommend having some money in REITs (although only a paltry 10%). Buying the stocks of home builders is another way to "play" the real estate market as there is a direct correlation between the two. You can also invest in real estate by owning a rental home, duplex, vacation home, timeshare/fractional ownership or even owning a small strip center. This is my preferred way of investing in real estate because you need very little money to get started. Banks love to loan money for real estate purchases, but you would be hard pressed to find a bank to loan you money to buy stocks. Plus, with 1031 exchanges, you can defer the tax implications of selling real estate. I will write posts on this later, but you can get a good idea by reading my post, how to become a landlord.
  • Alternative Investments- This includes so many different things: investing in a hedge fund, starting your own business, investing in a partnership or private company, investing in art, wine futures, foreign currencies, vintage automobiles or anything that you can buy at one price today and sell for a higher price in the future. Again, these tend to be the riskiest of investments so only invest up to 10% in these various ventures.

To recap, I think the best balance of investments is the following:

Cash (6 months of expenses) - approximately 10%

Bonds- 0-10%

Mutual Funds- 0-10%

Index Funds/Electronically Traded Funds- 50%

Individual Stocks- 10%

International Stocks- 20% (you can invest in individual stocks through ADRs, but I prefer index funds for international stocks)

Real Estate- 10%

Alternative Investments- 10%

The numbers don't exactly add up if you have bonds or mutual funds, but if you do just subtract the total from Index Funds. I will dedicate a post for Index Funds because they deserve the attention. Until then, take care and happy investing.


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