I have been a little lazy on the investment front during my three months in early retirement. I haven’t bought or sold anything in my portfolio. Not that it really matters, since you shouldn’t do a whole lot to your investments anyway. I like to sit back, prop my feet up, and let my investments grow over time. It’s a beautiful thing, really, watching your wealth grow. It’s like a skyscraper shooting skyward or a young child metamorphosizing into an adult.
But forget cheeky children and soaring skyscrapers. A better way to think of your investment portfolio is as an ant colony in your backyard. I happen to have fire ants in my backyard. They are very industrious (and painful) little creatures. A single tiny ant can’t do very much work by itself. But when there are thousands of ants working in concert, the colony tends to grow. New baby ants are born. The colony expands to provide more housing for the new arrivals. Every few months I’ll spread poison ant bait on the yard in order to fight off the expansion of the ant colony. The colony shrinks. I get my yard back temporarily. Then a few months later, I see the ant colony has regrown.
The ants are robust and continue to regrow their colony year after year because they spread out across my whole yard. I try to kill them all, but I invariably miss an ant hill somewhere in my yard. These ants are unconsciously performing geographic diversification across the entire world of my yard. The result of the diversification is survival.
The Way of the Ant: Diversification
Your investment portfolio is like an ant colony. If your portfolio is diversified like mine, then you own shares of thousands of different companies all around the world. Each individual company you own contributes very little to the portfolio performance. But when you have an army of companies working away in your portfolio, the investment returns add up. If one individual company suffers financial catastrophe and goes bankrupt, your portfolio will have a tiny amount of shares worth zero. But, like the rest of the ants in the colony, the other shares keep working hard to grow the portfolio, oblivious to the demise of their fallen brethren.
Owning the stock of thousands of different companies is one method of diversification. The performance of a single company won’t be noticeable in your overall investment returns. Just by the force of sheer numbers, you can own dozens of companies that do really poorly, yet in a pool of thousands of companies, the impact of poor performance of a few will be muted.
Another way to diversify your portfolio is to buy companies from all over the world. This strategy is similar to the ants’ strategy of building nests all over my yard. Rain may ruin their nests in one area of the yard. I’ll kill many nests with my ant bait in many other areas. But some nests will always survive.
Across the entire world, economies tend to perform differently from year to year.
Sometimes Asian economies do really well. Other times the European Union countries outperform. Then other years the US economy performs the best. If you spread your investments around the world, you don’t have to make a bet on one particular country or region. The US stock market represents between one third and one half of the total publicly traded investments in the world. Investing only in US companies means you are ignoring half to two thirds of the investing world and making a concentrated bet on the US of A.
I don’t want to go against the rest of the world and bet only on the US, so I have a significant share of my investments in developed countries and emerging markets around the world.
You can also diversify across different sizes of companies (“market cap” or market capitalization). Some research has shown that stocks of small companies outperform stocks of large companies. I buy into that research and I have certain parts of my portfolio devoted to small capitalization stocks.
Value stocks, or those stocks that have low prices compared to their earnings or book value, have a similar tendency to outperform (as suggested by some research). I subscribe to that theory, and have a tilt toward value stocks in my portfolio.
Some people have an investment strategy of buying whatever stocks or funds their friends tell them are awesome. Or picking last year’s best performers. Hey, good luck with that but it’s hard to call it an “investment” or a “strategy”.
I try to spread my investments around to a number of different asset classes. I know some asset classes will do poorly in any given year, while others will far exceed “the market’s” average return. Spreading investments across many different asset classes means I’m going to get different results than “the market”. The S&P 500 index, a measure of the 500 biggest publicly traded companies in the US, might generate a 20% return this year, but I might only make 15% since I’m invested in a large variety of companies that aren’t in the S&P 500 index. Or I might make 25%. Who knows in advance? No one.
Here is an overview of my equities asset allocation and what it would look like with a $1,000,000 investment portfolio (let’s pretend that’s exactly what I have):
When you look at this asset allocation, you may notice that half the assets are US investments and half are international investments. I also play favorites with value stocks and small cap stocks (both in the US investments and overseas investments).
Real estate (held through REIT’s) comprises 11% of the portfolio. This is my only “alternative” investment – no commodities or gold here!
There are some relatively volatile asset classes in the portfolio – US and international real estate, emerging markets, and international small cap. Each of those volatile asset classes represents 5-6% of the portfolio. These volatile asset classes can drop way more than the broad market, so I didn’t want to take too much risk in any one area. They also provide out-sized returns in some years. These volatile asset classes tend to move independently from each other (to some extent), and can sometimes dampen drops in the broad market (if real estate continues to do well, for example).
Before I close, I want to touch on a couple of subjects so my readers aren’t led astray.
My asset allocation is somewhat complex, with the aim to squeeze out maybe an extra one percent of return by taking on a little more risk. I present my asset allocation here because readers often ask me “what does your investment portfolio look like?”. Here it is!
If you are a beginning investor, you may want to keep it really simple and pick a target retirement date fund (check out Vanguard.com for options). Or get a little more complex and mix a Total US Market fund with a Total International fund. I’ll expand on portfolio suggestions for beginning investors in the future.
You may noticed that I have presented a 100% stock portfolio. That’s almost what I own right now, with only 5% of my total portfolio in cash or bonds. Since I’m recently retired, I need to increase my cash and bond allocation to probably 10% at a minimum. My cash and bond holdings are so small that I omitted them from my summary of asset allocation. In addition, I’ve never explicitly targeted a specific percentage for cash and bonds (other than zero percent) so my current target asset allocation is presented above.
If you are risk averse at all, you’ll want more cash and bonds in your portfolio than what I have. It can be a bumpy ride at times with nearly 100% stocks in my portfolio.
In my next post, I’ll show you how I use my asset allocation to guide my investment decisions. Here’s a quick preview of one tool I use. I have found the easiest way to track my asset allocation is with Personal Capital (review here). A peek at the Personal Capital asset allocation tool:
Readers: Thoughts? Do you have an asset allocation? If not, what is your investment strategy?
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