Here’s why you want to go beyond building a diversified stock portfolio and why you should invest in good mutual funds.
Are you a prudent investor? If you are, then you’re bound to practice good asset allocation. This means that you have worked to create and develop an investment portfolio that’s diversified and well balanced, such that your funds are allocated across various asset classes. This is what many investors do in order to control risk when they invest.
Let’s Review Asset Allocation
Asset allocation is a strategy that an investor performs in order to distribute their investments out among the different types of investment classes such as bonds, stocks or cash. Some popular asset classes that most investors end up investing in are the following:
- Bonds
- Cash
- Foreign Currency
- Collectibles
- Commodities
- Precious Metals
- Real Estate
- Stocks
The practice of diversifying your long term funds among all these investment categories does a lot to control the risk of loss. The reason for this is because the investment performance (or rates of return) of these asset classes are not well correlated: when one category is performing poorly, another may be doing well, thereby balancing out the total returns and performance of your overall portfolio.
Most asset classes are only related to each other in an indirect fashion (market relationships of distinct investment classes are loosely correlated), so that when one class is in a bullish trend, other classes may be down in the dumps. Because you can’t predict just how markets and investments will perform in the future, realize that your best performing asset for one year won’t necessarily be the best in the following year. Having an asset allocation strategy takes away the guesswork and worry over where you should put your money, year in and year out.
In short, the reasons for wanting to disperse your investments among different types of investment classes are these:
- It’s difficult to pick which asset class is going to turn out to be the most successful one during a given year.
- Individuals who jump around from one type of investment to another often end up less successful than those who have positions across many asset classes.
Historical Investment Returns of Asset Classes
To get some additional perspective on asset allocation, let’s check out just how well the different asset classes have performed over time. This cool Motley Fool table shows us how investment categories stack up against each other during the last decade:
Wow, this is quite an eye opener! Domestic stocks have performed dismally from 1999 through 2009 (with a return of -26% for the S & P 500 index), while gold and bonds have done the best. That’s why it’s not a good idea to be 100% invested in stocks! One day stocks will make a comeback, but who knows when that day will come?
{ 2 comments… read them below or add one }
I’m disappointed that you recommend ‘good mutual funds.’
You mention that one characteristic of such a fund is the manager’s reputation. What you don’t mention is that managers change too frequently for investors to really keep track of who is in charge.
In addition, statistics are available that show that funds which outperform one year are NOT more likely to outperform the next year. Sure, there are stars in every field, but those star managers don’t run no-load funds.
A prudent investor needs more than asset allocation to protect the value of his/her portfolio. That investor needs a guarantee that losses will NEVER be too large and in fact – the loss limit can be established in advance. It possible to achieve that, but the vast majority of professional advisors fail to teach their clients about collars. There’s more to investing than just proper asset allocation.
Mutual funds and asset allocation are for your average retail investor. At the very least, this is what you can do to participate in the stock market while controlling your risk. More sophisticated investors can certainly do more. By learning more about investing, you can do much with the money you already have. But some of us don’t have time to develop that kind of acumen, so we leave it up to “good mutual fund managers” to help us — or better yet, we find index funds to simply track market returns.
If you’re beating the market through other strategies, then good for you — but most people can’t.