Fixed Income

Asset Classes For Portfolio Diversification

“Don’t put all your eggs in one basket,” is a traditional idiom that warns us not to risk everything on a single venture.  If you divide your eggs into two baskets, and one basket is dropped, you have still preserved half your eggs.  Applied to investing, this strategy is referred to as diversification.

Many years ago, when I was in the financial planning business, “diversification” was interpreted to mean, “Divide your investments between US stocks and US bonds and make sure the stocks cover all the market sectors.”  Today, even the average investor can be much more sophisticated in portfolio diversification.  Using Exchange Traded Funds (ETFs), any investor can diversify much more broadly than was possible in the old days.

For example, you shouldn’t limit yourself to only US stocks and bonds.  It is very easy to invest in foreign stocks and bonds using ETFs.  Going back to our egg-harvesting example, international diversification is analogous to, “Even if you have your eggs divided into two baskets, don’t let the same person carry both baskets.”  This way if one person (country) stumbles, you have another person carrying some of your eggs.

How to Diversify

The diagram below illustrates how I approach asset diversification.  It may be a little complicated for some people, but it illustrates my view of the investment universe.

Asset Diversification

As you move from left to right in the diagram, each box represents a filter or a categorization for the asset to the left.  For example, both Stocks and Bonds are first divided into either Domestic or Foreign.

To be more accurate, I should have called “Stocks” “Equities” because further to the right I divide them into Stocks, Funds/ETFs or Options.

For each Domestic Stock, I categorize it by my goal for that stock.  My goals are either Growth, Income or High Risk/Reward.  Both Growth and Income Stocks are intended to be held long-term, while High Risk/Reward Stocks probably can’t be held for very long because they are volatile and were purchased with the hope of a good short-term gain while being watched carefully.

If a Domestic Stock can’t provide me with Growth, Income or the prospect of a short-term gain, I shouldn’t own it.

Foreign Stocks are first classified as Developed Markets or Emerging Markets before assigning each Stock to a Sector.

Second in importance, after the investment goal for a Stock, is the business Sector it falls into.  Most often, you see sectors categorized in a couple of ways:

Morningstar Sectors S&P 500 Sectors
Business Services
Consumer Goods Consumer Staples
Consumer Services Consumer Discretionary
Energy Energy
Financial Services Financials
Health Care Health Care
Industrial Materials Materials
Hardware Industrials
Software Information Technology
Telecommunications Telecom Services
Utilities Utilities

These categories are too granular for me.  I divide stocks up into eight categories:

My Sectors

  • Technology
  • Consumer
  • Health
  • Energy
  • Financials
  • Industrials
  • Utilities/Telecom
  • Commodities

I group Consumer Staples, Consumer Discretionary, Consumer Goods, Consumer Services and Media all together into “Consumer.”

I also group Telecommunications Services (e.g. AT&T, Verizon) and Utilities (e.g. Con Edison, Duke Power) into one category.  The rationale here is that they are both semi-regulated services for the consumer that bill monthly and usually pay dividends.

There is one obvious overlap/redundancy in the diagram.  One of the Stock Sectors is “Commodities” and one of the major asset types on the left is also “Commodities.”  Following the Commodities major type all the way to the right shows that one of the three ways to invest in Commodities is Producer Stocks.  These Producer Stocks also fall into one of two Stock Sectors: Commodities or Energy.  The reason I have this in two places is because many stock ETFs are diversified across Sectors including Commodities and Energy, so I have Sectors for this.  Other Individual Stocks or specialty ETFs are exclusively Commodities, so they go into Commodities Producer Stocks or Commodities ETFs.

Both Foreign and Domestic Stocks are classified as either Large Cap or Small Cap.  After you have allocated a portion of your portfolio to Domestic/Foreign, Goal/Market, Sector and Capitalization, you can put that money into either Individual Stocks, Mutual Funds or ETFs.  For Domestic Stocks, I also consider Options.

The diagram shows a similar treatment for classifying the other investment types.

I have a separate major asset type for Gold & Silver.  In a previous post I explained why I don’t consider Gold to be a Commodity; it should be thought of as the Universal Foreign Currency.  However, I only put fiat (paper money) foreign currencies into their own major asset type — Currencies.

Gold could be a major type all by itself, and Silver could be under Commodities, but Gold and Silver are enough alike and track together well enough to lump them together.

Why Bother?

So, why do I bother with this taxonomy of assets?  Two reasons:  1) If you already have an investment portfolio, you can see what percentage of it fits into each box.  This will reveal holes in your coverage which you can decide to ignore or fix.  2) If you are planning a portfolio from the top down, you can allocate percentages to each box according to your individual needs, goals and philosophies.

Although I am not as rigorous as the diagram might indicate, I do try to keep track of the percentage of my portfolio I have allocated to each box.  If I think I’m too heavy or too light in a category, I will fix it.

For many investors, this level of analysis will be overkill.  There are so many category possibilities that you may not have enough money to allocate to all, or even most, categories.  That’s perfectly OK.  In fact, even if you do have enough assets, you may choose to put nothing into one or more categories.  For example, contrary to conventional wisdom, I have almost nothing in Bonds of any type.  I have very little in the Currencies box or the Other box.  When I was an entrepreneur, all my assets were in the Other box.

How Much Should Be Allocated to Each Box?

This is the fundamental question, and, unfortunately, one answer does not apply to everyone.  In fact, even if every investor agreed with my taxonomy and had lots of money to invest, each investor would probably have a different allocation.

For example, let’s look at a traditional (old-fashioned) allocation strategy.  The following is copied from a Schwab newsletter I recently received.  They gave an example of three different portfolios:

Conservative Moderate Aggressive
15% Large Cap 35% Large Cap 50% Large Cap
0% Small Cap 10% Small Cap 20% Small Cap
5% Foreign Stocks 15% Foreign Stocks 25% Foreign Stocks
50% Fixed Income 35% Fixed Income 0% Fixed Income
30% Cash 5% Cash 5% Cash

Large Cap and Small Cap both refer to US Stocks.  Fixed Income usually means Bonds.  For Foreign Stocks, Schwab recommends for all three portfolios:  65% Foreign Large Cap, 15% Foreign Small Cap and 20% Emerging Markets.

As you can see, this is a much simpler diversification strategy than I have for myself.  It is easier to explain and (more importantly) to sell.  I can see the logic in their strategy, and I suspect that most investors are not even this diversified.  At my age, they would recommend that I have the Conservative portfolio, which I most certainly do not have.

Their portfolios completely ignore Gold & Silver, Commodities, Real Estate and Currencies.  I can understand this because the only Real Estate most people have is their home; Currencies are difficult to trade; and Gold is for paranoid nut jobs (Just kidding. I’m putting words into Charles Schwab’s mouth).  But even in Schwab’s simplified model, it takes three portfolios to meet everyone’s needs.

If I go into too much detail on how to allocate investment assets, I might cross the line into giving investment advice, which I am not qualified to do.  That being said, I think when it comes to stocks, I like to have between 60/40 and 40/60 allocated to Domestic/Foreign.  The same could be said for Developed/Emerging in the Foreign Stock category.

When it comes to Gold, even Jim Cramer recommends 10% to 20% of your assets in Gold, and I agree with him.

When it comes to Real Estate, I don’t include my home in my portfolio.  I realize that for many people, their home is their largest investment, but I choose to put as little money into my home as I comfortably can.  In fact, a case can be made for renting, but that could be the subject of another blog posting.  I do think that some of your assets should be in Real Estate, even if it’s your home.

I am also a fan of Commodities, especially Agricultural Commodities.  We are entering into a period of global food shortages, and I think this is a good investment category.

When it comes to Currencies, most people should probably not put too much money into this category.

Cash is probably the most important category, because it is the first box a beginning investor should fill.  If you don’t have enough Cash saved to cover at least four months of bare-bones expenses, you probably shouldn’t have any other investments.

I think I’ve rambled on long enough on this subject.  Maybe later I’ll have a few thoughts on some other aspects of my diagram.

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Sunday, March 6th, 2011 Gold, Stocks 1 Comment

Bond Funds Aren’t the Same as Bonds

First of all, let me state that I am not advocating investing in Bonds or Bond Funds at this time.  My purpose here is to explain why Bond Funds aren’t the same as Bonds.

What is the purpose of investing in a Bond?  Bonds are supposed to provide a modest income stream while preserving your investment.  If you buy a Bond, all you have to do is hang on to that Bond until it matures, and you will get back 100% of your initial investment.  The only risk is that the Bond issuer might go bankrupt.  Even if  the issuer does go bankrupt, Bond holders are in line ahead of investors to get some of their money back.  There have been a few spectacular exceptions, but most “investment quality” Bonds mature and return the principle to the Bond holder.

All the years you hold the Bond, waiting for it to mature, you receive steady, guaranteed interest payments.  Because of the safety of your investment, you are willing to accept interest rates that are a little less than you might be able to receive in other investments.

During the time you are holding the Bond, its “street value” will go up and down.  Unlike stocks, the value of the Bond, after it is issued, doesn’t depend as much on the strength of the entity that issued the Bond, as much as on prevailing interest rates.  If your $1,000 Bond pays you $40 dollars in annual interest, you are getting 4% interest.  If new Bonds being issued are paying 6%, you would only be able to sell your Bond for about $667.  By paying $667 for your Bond, the $40 that the new owner receives annually is 6% of what he paid for the Bond.

Conversely, if prevailing interest rates go down to 3%, a buyer would probably be willing to pay you $1,333 for your Bond.  The new buyer would be getting 3% interest on that Bond.

As a Bond holder, you don’t have to worry about the ups and downs of your Bond’s value.  All you have to do is wait until the Bond matures and you will get $1,000 for it.

Corporate Bonds are usually sold with a face value of $1,000.  In order to diversify your Bond portfolio, you would have to buy Bonds of at least five different issuers requiring an investment of at least $5,000.

In addition, you wouldn’t want all the Bonds to mature at the same time.  Because you don’t know what the interest rates will be when your Bond matures in five, ten, twenty years or so, you would like your Bonds to mature at different times.  That way, when you have to reinvest the $1,000 from a matured Bond, only a portion of your portfolio will be locked into the new interest rate.  For diversity of issuer and maturity date, you might want to invest $10,000 in ten different Bonds.

The average investor would probably need to use a broker who specializes in Bonds to achieve diversity of issuer and relative stability of interest rates.  Bonds aren’t as easily bought and sold as stocks, and the broker’s commission (spread) tends to be greater than with stocks.  This is why Bond Funds were created.  For purposes of this article, I am lumping Bond Mutual Funds and Bond Exchange Traded Funds (ETFs) into the same category.

Bond Funds own lots of Bonds from lots of issuers with different maturity dates.  This diversity reduces the risk of default from small to miniscule.  It can also increase the interest paid by having some higher risk, higher interest Bonds mixed in with lower risk, lower interest Bonds.  Bond Funds are traded like stocks (ETFs) or like mutual funds.  The commissions are low and the prices are published daily.

All this makes it sound like Bond Funds are the best thing since homogenized peanut butter.  You get lower risk and higher interest without having to invest $10,000.  For ETFs and many mutual funds, there is no minimum required investment.  Bond Funds are within the financial reach of almost everyone, and you can buy them as easily as any other investment.

However, with Bond Funds, you give up one important attribute of Bonds – security of capital.

No matter how long you hold shares in most Bond Funds, you are not guaranteed return of your initial investment.  Like Bonds, the daily value of Bond Funds goes up and down, but there is no maturity date.  You have to pick a time to sell your shares in a Bond Fund.  You could sell your shares for more or less than you paid for them.

Bond Funds

The chart above graphs the weekly price over the last five years of two Vanguard Bond Mutual Funds.  The black line is an intermediate-term corporate Bond Fund, and the gold line is a long-term corporate Bond Fund.  You can see that your initial investment could have lost as much as 14% or gained as much as 12% for the long-term Bond Fund.

Because of this, I don’t see much difference between Bond Funds and dividend-paying Stock Funds.  You get a fairly stable income stream and the value of your investment goes up and down.  Until 2013 at least, dividend payments are taxed at a lower interest rate than corporate Bond Funds’ interest payments.  Interest from municipal Bond Funds can be tax-free.

To be fair, this volatility is nothing compared to the volatility of the S&P 500 stock index.  The chart below compares the Vanguard intermediate-term Bond Fund with the S&P 500 index.

Bond Funds vs. S&P500

Today, the yield of the S&P500 (SPY) is 1.69%, while the yield of the Vanguard intermediate-term Bond Fund (VBIIX) is 3.17%.  For the past five years, the Bond Fund value has risen about 9% (vs. about 1% for the S&P 500) and has a better yield.  The main reason for the increase in value of the Bond Fund is that interest rates have been declining for the past couple of years.  The Bond Funds took a major hit around October, 2008 when everything (Bonds, Stocks, Gold) crashed.  But after about three months, the Bond Fund resumed its inverse tracking of interest rates.

The reason I am not recommending investing in Bonds or Bond Funds right now is that I expect interest rates to rise over the next few years.  This means that existing Bonds will be cheaper when interest rates are higher and the yield will be better.

As long as you realize that Bond Funds do not preserve your capital the way individual Bonds do, Bond Funds can be a useful part of your investment portfolio.  Just remember that Bond Funds, like Stock Funds, fluctuate in value, and there is no guaranteed safety of your investment.

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I am not a registered financial advisor. I only offer opinions, and sometimes these opinions veer off at weird angles from conventional wisdom (That's probably why you are here). My advice is, "Don't take my advice." Read my sidelong glances at economic issues and form your own conclusions.

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