Most people come into our office not knowing the difference between a stock and a bond, but knowing that they "should be investing." Different people will have different goals, timelines, and risk acceptance levels. Your portfolio (your "basket of investments") should be chosen carefully to weigh risk and return, and avoid fees whenever possible. There is no one right way to invest, but you should always follow a few basic guidelines.
Asset Allocation is Key
The difference between stocks and bonds? It's pretty simple: Stocks are a way for you to own a small part of a company. Bonds are essentially loans to companies, with a promise that they'll pay you back. With stocks, you get paid when the company makes money, since you're part owner. With bonds, you get paid with the interest on the money you loaned out. And this is the most important part: since stocks are ownership stakes, they are much riskier than bonds, with less protection. Because they are riskier, the return you get on your investment is expected to be higher.
There are other alternative asset classes that are sometimes used to diversify portfolios further: commodities like gold and silver, real estate, cash, and other "alternatives." But stocks and bonds (sometimes called "equities" and "fixed income") are the two main asset classes you will have in your portfolio. Your balance of stocks and bonds will determine how aggressive or conservative your portfolio is, and is also the most important factor in portfolio performance. Being too aggressive (too many stocks) or too conservative (too many bonds) can be risky in different ways. An all-stock portfolio may be way too volatile and risky in the short term. An all-bond portfolio may have returns too low in the long term, leading you to run out of money. The biggest decision you will make is the balance of stocks and bonds.
Basic Investment Principles
Risks: There are numerous risks in investing, of which price volatility and inflation arguably are the greatest. There is no ideal asset that keeps a stable value, is liquid, and earns enough to keep ahead of taxes and inflation. Therefore, in building a portfolio, you must make compromises.
You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets.
- Peter Lynch
Your Time Horizon: Your time horizon, the time between now and when you will need the capital you are investing, is a crucial factor affecting your volatility risk and underlies your choice between interest earning investments (such as cash or bonds) and equity assets (such as common stock and stock mutual funds).
- Over longer time horizons, inflation risk has tended to dominate, so it is wise to emphasize equities.
- Over shorter time horizons, volatility risk dominates, so it's wise to emphasize interest earning assets that don't fluctuate much in value, such as short-term bonds, Treasury bills, money market accounts, CDs, etc.
- Most of us underestimate our time horizon, so we tend to have too much in interest earning investments and, thus, are over-exposed to inflation risk.
The stock market is a device to transfer money from the impatient to the patient.
- Warren Buffett
Diversification: The wisest way of controlling risk and enhancing return is through diversification across a number of different asset classes. This means having within your portfolio some stocks, some bonds, some international stocks, some real estate and perhaps some assets that further hedge the value of the dollar, such as natural resources or gold coins. When the market for one type of asset is depressed, the market for another asset may be booming. Thus a portfolio diversified across asset classes is likely to bounce up and down in value less than a portfolio invested entirely in one type of asset -- such as stocks, or real estate, or bonds -- yet the diversified portfolio is less subject to inflation risk than a portfolio invested entirely in bonds or Certificates of Deposit.
We have a few tenets we live by, apart from the basic investment principles above:
- Be boring. We think investing should be like watching paint dry - completely tedious. You shouldn't be day trading, trying to time the market, or checking news reports daily. If it's exciting, you're doing it wrong!
- Keep costs low. That means avoiding fees whenever possible. And whenever there is an inevitable fee (such as a mutual fund expense ratio), we will find the lowest cost option and disclose it with full transparency. You should always know how much you're paying to invest.
- Stay the course. We plan with your future goals in mind. If those haven't changed, neither should your investment plan. It's easy to get sucked into an overly optimistic or pessimistic mindset based on the recent results of the market, and want to chase returns. But a good investment plan shouldn't change just because the market wobbles. Remember the timeless advice for when markets get shaky: "Don't just do something - stand there!"
The Funds We Invest In
Vanguard was founded by Jack Bogle, the man who invented the first index fund for individual investors. One thing that sets it apart from other mutual fund companies is that it is owned entirely by shareholders. which is one reason why costs have stayed so low at Vanguard over the years. They are a fantastic company, and if you're going to DIY your own investments, you would do well to stick with their funds.
Dimensional Fund Advisors is a company that uses academic research to drive its asset allocation decisions. As a result, DFA slightly tilts their index funds towards small capitalization and value stocks. If you want to learn more, here are a few videos that talk about their approach to investing.
- VIDEO: ORIGINS OF DFA
- VIDEO: AN INTRODUCTION TO DFA
- VIDEO: DIMENSIONAL APPROACH TO THE SCIENCE OF INVESTING
Both companies have options for"Socially Responsible" or "Sustainable" investing, which seek to promote environmental, social, or governance factors in their investment selections. If you are looking to invest according to your values, we have portfolios which will reflect those priorities.
All of us here at Natural Bridges Financial Advisors are invested in Vanguard and DFA funds with our own investments, and regard them highly as effective fund choices. We wouldn't invest your money any other way!