“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.” Robert G. Allen
When you have some savings, it is good to invest and allocate your money to work.
Keeping too much of your money in your checking account is too tempting to spend and counterproductive.
The best time to begin investing is now—the earlier in your life, the better your wealth accumulation.
As you grow your savings, you want to consider your investment goals, risk tolerance, time horizon, and where to invest.
How to invest and allocate may differ on a range of factors. You may adopt different strategies based on age, income, family responsibilities, lifestyle, financial resources, risk tolerance, and desires.
You are diversifying your portfolio by considering various asset classes: stocks, bonds, money markets, and real estate. We have some guidance for new and experienced investors: Investing Rules For Success-It’s Not Rocket Science!
At different points in your life, your priorities may be to realize one or more of the following objectives:
- Buy your own home, finance your children’s education, take vacations, buy a car, or start a business.
- Gain wealth and financial freedom.
- Increase your current income or add some financial flexibility.
- Meet your retirement needs.
- Preserve your capital.
- Set risk tolerance
There are degrees of risks for all types of investments. The exception is when you keep all your money in savings accounts in the bank where they are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per person and per bank account. However, you will earn little to no money.
Risk and reward, sometimes referred to as your return, are positively correlated. The risk/return relationship means that higher returns come with greater risk, while low-return investments come with low risk.
If your time frame is short given your age or needs, you may want to opt for low-risk securities versus someone who can invest for a 20-30 year horizon. They can better absorb risk and volatility.
10 Tips For Diversifying Your Investment Portfolio:
#1 Asset Allocation
You should distribute your money among different assets based on your age and lifestyle. You can afford more risk in your portfolio at a younger age and be aggressive with more growth, such as stocks, than someone closer to retirement age. A good rule of thumb for allocation is to subtract your age from 100, and that would be the percentage of stocks in your portfolio.
For example, a 30-year-old could keep 70% in stocks (100-30) in the portfolio with 30% in bonds. On the other hand, a 60-year-old should reduce risk exposure and have 40% in stocks and 60% in bonds.
#2 Diversification Is A Must
Don’t put all of your eggs in one basket. Instead, you should be distributing your money among various classes of securities using an appropriate allocation. You should diversify within each security class. Investing in 10 energy stocks is not diverse. Branch out into multiple industries with different characteristics (e.g., high growth and strong dividend history).
# 3 Growth Stocks
Stocks provide more growth, appreciating faster than other financial instruments over the longer term. However, the stock market can be volatile, as witnessed by the 57% decline during the Great Recession. It is a good idea to buy mutual funds or ETFs when you are first investing to achieve a diverse stock portfolio.
#4 Money Market Securities for Cash
Investors can easily convert money market securities into cash without loss of value. They are low risk/ low return instruments with liquidity, stability and provide access to money. The Treasury bills rated AAA are the closest to risk-free securities. They can be bought individually or as part of a MM mutual fund, including other short-term securities.
While these securities are known for safety, they do not provide much income. The Fed has battled the COVID-impacted recession in 2020. They reduced the fed funds rate to virtually zero and used aggressive measures. As a result, its needed actions have extended the low yield environment, challenging investors to find income from low-risk securities.
#5 Bonds With Different Characteristics
Investing in bonds is desirable for more predictable income streams. It is desirable to invest in various bonds: treasury bonds, municipal bonds, and corporate bonds. These all differ in terms of credit risk, liquidity, and tax benefits.
#6 Buy-Hold Strategy and Don’t Be Greedy
It is a prudent idea when building an investment portfolio to use a buy-hold strategy rather than trading securities. That said, don’t be afraid to pare down a holding that has appreciated too fast or begins to occupy a more significant proportion than you prefer. An old Wall Street saying is: “Bulls make money, bears make money, pigs get slaughtered.” I mean, don’t be greedy.
# 7 Understand factors that impact the financial markets
You should know the role of interest rates, their connection to inflation, and how the Federal Reserve’s monetary policy can significantly impact the financial markets. To calm the markets, the Fed stepped in with substantial liquidity to combat the economic downturn caused by the pandemic in 2020. The Fed reduced already low-interest rates, making it hard to find income for savers and risk-averse investors.
#8 Have Some Exposure to Global Markets
Investors seek potentially higher returns and exposure to faster-growing global markets, especially when the US markets are experiencing weakness. The best way to do that is to find an ETF or mutual fund representing the exposure you want.
# 9 Start Early To Benefit From Compound Interest
The earlier you begin to save and invest for retirement and investment accounts, the longer the time to take advantage of the power of compound interest. Start in your 20s. Find a compound interest calculator, plug in some numbers, using what you can set aside monthly for investing.
Use a reasonable return (don’t use 12%, which I have seen and find it challenging to achieve. Instead, try 7%) and provide the number of years you have until your retirement.
# 10 Rebalance Your Portfolio Periodically
It is essential to periodically review your investment portfolio and consider rebalancing the various assets. Review it annually and make changes based on significant life milestones. Meeting with your financial advisor or accountant is an excellent way to review where your investments stand relative to you and your lifestyle.
Different Asset Classes
With the highest historical S& P 500 annual returns of 10% relative to money markets and bonds, stocks (“equities”) are attractive instruments to own in your portfolio. Investing in stocks is among the best ways to build wealth.
Common stocks represent equity ownership in a publicly-traded company or business enterprise. Your holdings reflect the number of shares you have. As common stockholders, you have voting rights on major company issues determined by your fractional share amount.
These equity shares are different than money market and bond securities, commonly referred to as debt securities. Owners of these instruments have creditor rights and do not vote like equity owners.
The Wealthy Get Wealthier, But You Can Get Rich Too
A recent study by the Federal Reserve in 2016 found 51.9% of families owned stocks either directly or as part of a mutual fund for investment and retirement accounts. However, the distribution of stock ownership by wealth percentile shows that the top 10% hold 84%, the next 10% have 9.3%, and the bottom 80% save 6.7%, according to a 2017 paper published by NYU Professor Edward N. Wolff.
Asset Allocation And Diversification
Recognize the challenges of investing. I have been an investor, an equity analyst, and I teach finance courses in college. As part of their requirements, students develop diverse stock portfolios using the stock market game. To a great extent, I share my experiences and mistakes during the bull and bear markets. Nothing prepares you for the next great crash as we had in March 2020. The unexpected pandemic of 2020 caused substantial market volatility.
Many factors impact the stock market. Investors should have a basic understanding of the economy, differences between industries, and company fundamentals. You need to understand the basics when investing on your own instead of having a financial advisor or buying mutual funds.
Learn about the differences between stocks, bonds, money market securities, and other asset classes. Be aware of what you own, whether it is individual stocks, or through mutual funds in your portfolio, setting up a 529 Savings Plan, or as part of your retirement accounts. Stocks tend to generate high returns but naturally carry higher risks and volatility than money markets and most bonds.
How To Determine Your Allocation
You need to manage the risk with a balanced portfolio with assets distributed among stocks, cash-equivalent securities, bonds, and real estate.
Generally, a stock allotment guideline in your total portfolio considers your age deducted from 100. So if you are 30 years old, you should invest 70% of your portfolio in stocks with the rest in a mix of money markets and bonds. The 70% percentage is conservative and can go higher to 80% allocated to stocks.
However, a typical 60 years old’s portfolio should divide their ownership more conservatively: 40% in stocks with 60% in bonds and money markets.
Diversification is essential and your best means for reducing risk.
Holding a broad stock portfolio, along with a variety of bonds and money market securities, smooths out the bumps you encounter. Investing at an early age helps to weather the ups and downs in the financial markets and benefit from the compounding of returns long term.
Once the shares are publicly issued, they typically trade on the New York Stock Exchange or the NASDAQ. The stakes are accessible for all investors to buy and sell. If they are privately issued, they are closely-held, usually by a small group of individuals who may be founders or families owning a substantial part of the business.
Stocks tend to be the most common investment vehicle for households, either through tax-advantaged retirement accounts or taxable investment accounts.
Active Versus Passive Investors
Individuals and households can be active investors by buying the shares outright through brokerage accounts or Robo-advisors, thus becoming direct owners. Alternatively, as passive investors, they can buy mutual funds and exchange-traded funds (ETFs) representing indirect ownership of publicly traded shares.
If you are just beginning to invest and have limited resources and research time, consider buying a mutual fund or ETF. Exposure to only one or two individual stocks is too risky. I have different types of funds you can search for just below. Funds or ETFs will provide you with a more diversified basket of securities from the get-go. Later on, if you want to become more active, you can do your stock picking.
Those with more assets often have access to private money managers and hedge funds. Their fees are often higher than low index mutual funds and ETFs without necessarily providing higher returns.
Dividend income, dividend growth, and stock price appreciation determine stock returns. Related Post: How To Start Investing: A Guide For Investors
Choose from the different types of funds (or ETFs) that might fit your needs:
#1 Company market capitalization.
From large-cap company stocks with a capitalization of $10 billion to midcap stocks from $2 billion up to $10 billion range; and small caps of less $ 2 billion.
#2 Industry Sector.
You may be seeking one or more industries with different characteristics to counterbalance your portfolio. Adding tech, consumer discretionary, industrial, and finance companies would diversify risk.
# 3 Value stocks
Value stocks are stocks trading below their intrinsic value compared to their fundamentals. Benjamin Graham is the founder of this type of investing. Warren Buffett and Charlie Munger favor these strategies for their Berkshire Hathaway portfolio. Examples of value stocks are General Motors, GE, and Philip Morris.
# 4 Growth-oriented
Above-average growth comes with higher risk. These stocks appreciate at higher rates above the average for the market but don’t always pay dividends. Growth companies tend to plow their cash flow back into their business rather than pay dividends. A few examples of growth stocks are Amazon, Tesla, cloud companies like Salesforce, biotech stocks.
#5 Blended funds
A combination of value and growth stocks can offset some of the risks in # 4.
#6 Dividend Growth Stocks
This group contains companies that have above-average dividend yields like ATT, British Petroleum, REITs. They are presumed to be safer, defensive, and slower-growing companies. Look for high-quality companies that have a history of paying above-average dividends. These names provide less risk but provide exposure to stocks.
# 7 Dividend Aristocrats
An elite subsector of above-average dividend-paying stocks not only provides above yields but are known for 25+ years of dividend increases. Chevron and PPG Industries are in this select group.
An investment portfolio should have a mix of different asset classes with fixed income and equity to help you achieve asset allocation.
#9 Index To A Specific Market Benchmark
It is difficult for the best portfolio managers with the expertise to “beat the market.” These funds track market indexes’ performances like that of the S& P 500 or the Russell 2000 for smaller cap stocks. These are prevalent ways to participate in the stock market.
# 10 Target Date Funds
These mutual funds adjust the asset mix based on your age and retirement plans. Vanguard has many funds labeled by decade eg. “2040.” They are appropriate for 529 Savings Plans and 401K retirement plans and a taxable investment portfolio.
# 11 Domestic or Global Markets
Suppose you may want to add international exposure to a mostly domestic-only portfolio for higher growth, especially if the USS is experiencing weak or recessionary growth. Several funds provide equity or mixed (including bonds) basket of companies in many countries, regionally oriented like Asia, or specific markets like China or India.
#12 Specialty funds
Gaining in popularity are specialty funds that contain stocks that represent companies with strong social responsibility or sustainability. ESG funds are portfolios of equities or bonds which address environmental, social, and governance factors into the investment process.
Money Market Securities
Money market securities are debt securities and are also known as cash-equivalents because investors can quickly convert them into cash with little or no loss. These instruments are issued at a discount to par value by various issuers, borrowing for their short term needs. These generally mature in one year or less and trade in the secondary market.
The US Treasury issues Treasury bills; corporations raise short term capital through commercial paper (CP), banks issue negotiable certificates of deposits or CDs). A banker’s acceptance security is created by a company’s transaction with another and guaranteed by a commercial bank should the firm fail to pay the amount.
T Bills or Money Markets Account
Individuals and households would largely buy the more popular T-bills with minimum denominations of $1,000. Individuals can buy a pool of money markets as an FDIC-insured money market denominated account (MMDA) or money market mutual funds. The investor would be holding a bundle of different money market securities, including Euro CDs issued in US dollars by European banks at higher yields is often in the funds.
On their own, the other money markets have higher denominations ($100,000) and are out of reach for the average household. Institutional investors often own or trade these securities.
For example, a six month T-bill currently yields just 0.12% today, tracking our very low-interest-rate environment. Indeed, it is virtually risk-free security but has been more attractive to hold in a higher interest environment. While it is better than keeping your money in zero-interest savings accounts, it is not much in our pandemic-world of 2020. Historically, T-bills return 3.5% per year. The other cash-equivalent securities tend to trade at slightly higher yields than T-bills in a relatively narrow range and low yields.
Besides low risk, money market securities are for those that prefer liquidity and easy accessibility to money, particularly for your emergency fund. Today’s yields are significantly lower than historically based on the Fed’s actions to combat the pandemic’s effects on our economy.
In the early 1980s, these cash-equivalent securities were very attractive, providing double-digit high yields in the face of a tough economy with high inflation. Keeping at least a small amount of your savings in money market securities makes sense for low-risk low return investors, significantly when interest rates rise.
Older investors should be reducing their exposure to risky stocks and placing more of their portfolio in these securities and bonds
A Variety of Bonds
Like money market instruments, bonds are debt securities issued by the borrower at below par for a fixed face amount with a specific interest rate (called the coupon) and a specific maturity date when the issuer pays the principal.
To calculate your annual income streams from the coupon, you would receive an annual interest income of $40 on a $1,000 corporate bond with a 4% interest rate. The payment is paid semiannually or $20 every six months.
Bonds provide these predictable fixed income streams. Bonds vary in credit risk from the Treasury Bonds rated AAA to munis and corporate bonds with varying debt levels. There are also corporate bonds with high yields, so-called “junk bonds” because of their risky nature.
When you invest in a bond, you are effectively lending money to the issuer instead of owning part of the equity of a company when you invest in a stock. In the event of a default, a bondholder has a priority claim as one of the company’s creditors over stock ownership.
Relationship between bond prices, interest rates, and inflation
Bond prices and their yields have an inverse relationship, moving in opposite directions. When there is a high demand for bonds, bond prices rise, yield declines, and vice versa.
All money market securities and bonds have interest rate risk. As interest rates rise, the market value of existing debt securities tends to drop because newer issued bonds hav higher yields.
Warning: A Mini Macroeconomic Lesson For You
These securities also have inflation risk. There is a close connection between interest rates and inflation. Inflation refers to the rate at which prices for goods and services increase, reducing our purchasing power.
As inflation increases, so do interest rates. Interest rates, of course, are the amount charged by a lender to a borrower. The federal funds (“fed funds”) rate set by the Federal Reserve influences interest rates.
The fed funds are the interest rate at which depository institutions borrow and lend each other from their reserve balances overnight. That rate influences different interest rates, such as the prime rate, mortgages, and auto loan rates.
When inflation rises above the targeted 2% rate, the Fed, through its monetary policy, will raise the fed funds rate to stem inflation from going higher.
Related post: 11 Reasons Why Investors Need To Understand The Fed
As a bond investor, you don’t want your bonds to erode in value because of other bonds’ availability sporting higher yields. Issuers of Treasuries, municipal and corporate bonds know this so that they will offer inflation-indexed or protected securities. The yields on these bonds will adjust according to a formula linked to an inflation indicator like the Consumer Price Index (CPI).
Without that protection, a bondholder with a 4% interest rate is doing fine if inflation is 2% or below. However, at that same 4% rate, the investor will be losing ground on your returns if inflation increases to 5% or more.
Minimum denominations range from $1,000 for Treasuries, $5,000 for municipal bonds, and $1,000 or $5,000 for corporate bonds.
There are several different types of bonds with notable risk differences.
Treasury Bonds Are Safe and High Quality
In addition to the short term T-bills, the US Treasury issues Treasury notes (intermediate-term) and treasury bonds (up to 30 years). With these bonds, the Treasury is borrowing for long term needs as well as retiring debt. Longer-term maturities carry more yield based on more risk than short term securities. Like money markets, Treasury yields are historically low given the Fed actions that brought down interest rates when the pandemic impacted our economy.
Treasuries are considered virtually risk-free versus the other debt securities because of their triple AAA rating. Treasury investors have confidence in the full faith and credit of the US Government,
Historically, T-bonds returned 5.5% per year though they too are lower these days. Treasuries represent quality, safety, excellent liquidity and are modestly tax-exempt (holders do not pay state or local taxes). The primary risk in Treasuries is subject to interest rate and inflation risk. TIPs or Treasury Inflation-Protected securities are in demand as they adjust rates with the inflation-indexed CPI.
Treasuries are desirable for many investors, especially those seeking quality, safety, and capital preservation.
A True Story
I recall a story early in my Wall Street career when a friend of mine, a trader, had received an eight-figure bonus at the end of the year.
Curious, I asked what he was going to invest in with his bonus? With little hesitation, he practically yelled out, “Treasuries, of course!”
I was a stock analyst, and being surprised at his choice, I asked him why and he said, “Treasuries are safe, I have young children, I have all that I need, and I spend modestly, save abundantly, I donate generously, and I am risk-averse.” That made more than a modest impression on me.
Municipal Bonds Have A Unique Tax Benefit
State and local governments or municipalities issue general obligation bonds or revenue bonds for general long term needs, debt paydown, or infrastructure projects based on shifting population growth and regional employment. Minimum denominations are $5,000, so they are attractive for individuals and households.
Tax Exemption A Big Plus
One of the outstanding benefits of owning a municipal bond is favorable tax treatment. Muni bondholders have federal income tax-exemption, and sometimes even state and local taxes are exempt. As a result, your aftertax returns on these muni securities will be higher than treasuries and may exceed the riskier corporate bonds.
These securities are attractive, especially if your marginal tax rate is above 25%.
While rare, there have been some notable defaults, such as in housing. The default risk is historically low, below 1%. Muni bonds are generally safe, second to Treasuries in safety. An excellent way to minimize risk is to buy a municipal bond mutual fund bundled with various muni securities.
Corporate Bonds: High Grade Or High Yield
These debt instruments issued by corporations vary by their credit risk, growth prospects, and potential restructuring. The higher-quality corporate bonds are investment-grade bonds, rated triple BBB, or better. They generate low-to-moderate returns historically. Yield is impaired in these securities as well in 2020. Moody’s current yield for the highest quality (Aaa) corporate bond is 2.32% versus 3.02% a year ago.
Disappearing AAA Corporate Bonds
There are only two corporate bonds with the coveted AAA ratings left: Johnson & Johnson and Microsoft. In 1992, there were 98 companies with the highest credit rating. Companies started increasing debt levels associated with mergers & acquisition deals, leveraged buyouts, restructuring, damaging lawsuits, and the great recession.
High Yield AKA Junk Bonds
For risk-oriented investors seeking higher returns, high yielding corporate bonds could provide attractive returns. These are corporate bonds below investment grade and vary significantly. However, you need to do your homework as you would when buying individual stocks. I would recommend buying a high yield bond mutual fund readily available through Vanguard or Fidelity. Diversity is your best path to exposure to these risky instruments.
The riskier, higher-yield bonds may be called “junk” bonds. Historically, junk bond yields are 3%-7% higher yields than high-grade corporate bonds. Default rates are higher for junk bonds, rising to the mid-teens rate during the Great Recession. Debt-heavy companies or those restructuring often issue junk bonds. Today, investors seeking higher yields may want to consider high yield bonds in the 3%-4% range but carry higher risk.
Drexel Burnham And Michael Milken
The earliest part of my career began at Drexel Burnham, known for developing high yield bonds by Michael Milken and his role in that market. That high yield market ultimately forced the company into bankruptcy. Mixed thoughts aside, many companies I covered as analyst survived and prospered due to those high yield bonds.
Holders of corporate bonds do not have any tax benefits like treasury and municipal bonds. These bonds tend to have pretax yields higher than their brethren. Historical corporate bond returns average about 6% per year, below the 9%-10% return of the common stock. Bondholders are creditors who have priority claims in the event of a default, which stockholders do not have.
Rebalance Your Portfolio Periodically
It is essential to review your portfolio periodically and make sure it is balanced for your life. When you are young, you should take some risk given your longer investment horizon. As you grow older, you want to reduce risk by shifting more into predictable income streams.
Thank you for reading!
Have you reviewed your portfolio? Is it diversified enough? It is a good idea to work with a financial advisor or professional when considering changes. What strategies have worked for you? Please share your comments as we love to hear from you!
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.