If you find yourself hemming and hawing when friends bring up the subject of investment portfolios; if you consider the term pretentious or if you think only the rich can afford one, you may not be getting the most out of yours.
A portfolio is nothing more than a collection of financial assets. Nearly everyone’s got one—it’s just that many of us have only invested in essentials such as a roof over our heads. When it comes to stocks and bonds, we’re out of our element.
It doesn’t have to be that way, according to Michael W. Dunbar of Financial & Retirement Planners Northwest Inc. in Federal Way, and it shouldn’t be if you hope to maximize your nest egg for retirement.
The first thing to recognize is that man does not live or even retire by stocks and bonds alone. There also must be cash—or at least liquidity. The question is how to decide how much of your assets to put into each.
Stocks pay higher returns but are riskier. Bonds and cash represent lower risk but pay lower returns. Since 1926, major stocks have produced an average annual return of more than 11 percent, while bonds have averaged 5.3 percent and cash only 3.8 percent.
If only you could bank on those averages.
The risk associated with the stock market is demonstrated by the fact that $1,000 invested in the stock market in 1974, would have declined $735 by that year’s end.
Bonds, on the other hand, have built-in risks of their own. Bonds are essentially loans.
When your school district sells bonds to build a new school, for example, it is simply borrowing money to finance the construction. Collateral for the loan is the assurance of taxpayers within the district that they’ll repay the loan—or buy back the bonds. That’s why you get to vote on bond issues.
When you invest in bonds, you’re working the other side of the tracks. You’re committing your assets to build a school or a bridge or a public library somewhere with the promise that over the next several years you be repaid the amount of your loan, plus interest.
The two hazards associated with bond investments are credit risks and the potential impact of inflation. Credit risks are simply that the borrower won’t pay you back. Inflation risks are more complicated. Say you buy a $1,000 bond that matures in 10 years but inflation averages 7 percent over that time. When the bond matures, you’ll have earned interest on your investment, but the purchasing power of the initial investment will have dwindled to $500.
With cash, on the other hand, the risk of inflation is much lower since you can roll over your CD quickly in response to changes in the economy, and as inflation goes up, so do interest rates.
Many financial advisors continue to preach diversification—scatter your assets in order to minimize your risks. Others suggest that you base your decisions on your personal needs.
If you aren’t going to need the money for at least 10 years, put it into stocks. If you’re going to need it sooner, put it into bonds or cash.
Don’t go for quick returns in the stock market, warns Warren Buffett, chairman of Berkshire Hathaway Inc.
We’ve all read stories about people who made a fortune day-trading stocks and dreamed of making a killing overnight. We’ve also seen articles about people who’ve lost everything and killed themselves or the people that got them hooked on day-trading in the first place.
“If you aren’t willing to own a stock for 10 years,” says Buffett, “don’t even think about owning it for 10 minutes.”
Writing for the Moneywise section of Reader’s Digest, James K. Glassman points out that needs often change over time.
At age 30, he says, a combination of 90 percent stocks, 5 percent bonds and 5 percent cash may make perfectly good sense.
But suppose you’re just married and saving toward the purchase of a house in three years or you are 45, with your kids’ college tuition staring you in the face in the next five years, he continues. Bonds rather than stocks may make more sense.
At age 60, the best combination might be 60 percent stocks, 30 percent bonds and 10 percent cash.
But there’s no perfect formula, warns Dunbar.
“I now people who are 80 and stick everything they have in stocks,” he confides. “If it works, more power to them.”
How do you know for sure what sort of diversification ratio is best for you—and when?
Get professional help, Dunbar says, from a broker, a financial advisor or accountant you trust.
By george Pica, Business Examiner staff