Obviously when you're evaluating a dynamic issue, you need to gather information from multiple sources, including sources your disagree with. You need to get as close to complete information as you can.
That said, it is also sometimes useful to look for the simplest answer. When we look at what is happening in the economy right now, the simple solution is probably the following:
For 7 years, the Fed has kept bonds bid and forced investors into risk assets. That included equities. Now that the Fed is raising rates and implementing quantitative tightening, bonds (treasuries) are able to move down (yields going up). This makes shorter term government bonds more attractive. Some conservative investors that were forced into equities after the Fed began quantitative easing, will start to eye 10 Yr Treasuries. The yield plus safety is hard to pass up for these investors. As a result, there will be downward pressure on equities.
So what does that simple answer mean that stocks can't go up? No. It means that there will be a battle between earnings growth and bond yield appeal. It will likely be a bumpy ride until the end of this economic cycle.
Business owners and creatives are always asking me how to invest their (passive) incomes. My favorite method (but by no means the only strategy) is to use what is called a Core & Satellite strategy. I will describe it below.
[Disclaimer: Building your investment portfolio will depend on a number of factors, such as your risk profile, your time-horizon and your individual goals. This article should in no way be considered advice. You should meet with an adviser than can take into account your situation, when planning your portfolio.]
In order to maintain a well-balanced and diversified portfolio, a common strategy is to split your assets into ‘core’ and ‘satellite’ investments. The goal with Core and Satellite strategy is to increase diversification, while providing the potential for higher returns than a index fund alone might provide.
This strategy typically involves investing the ‘core’ of your portfolio in lower cost and (hopefully) lower risk funds, while your smaller ‘satellite’ investments tend to be more tactical. These tactical 'satellite' funds can also be passive, but they may be actively managed as well.
Why core and satellite funds?
The idea behind the core/satellite strategy is to give your portfolio some sort of structure. A portfolio lacking structure can lead to a mishmash of investments, which can result in unknown risk levels. Risk is something that all investors should understand.
Core and satellite is also relatively simple to rebalance every year, and it is visually easy for some people to understand -- a core with smaller funds surrounding it.
What should form the core of your portfolio?
Your core holdings should provide stability to your portfolio and should match your risk tolerance and investment horizon.
One option is to invest the ‘core’ of your portfolio in low cost index funds and your smaller satellite investments in actively-managed funds. Another option is to invest in an active “balanced” fund that has low fees. The goal is for a broad based fund with low fees and above average performance.
The core will make up 60-90% of the portfolio, and since it is low cost, you keep overall fee levels down on the portfolio. I prefer funds that aren’t overweight the mega-cap stocks. Rather, I like funds that are spread fairly equally between large, mid, and small stocks.
We also prefer that the core have exposure to developed foreign markets, like Europe, UK and Japan. We can get our emerging market exposure in one of the “satellites.”
What should form the satellite of your portfolio?
Satellites are commonly sector-specific or thematic funds in tech, biotech, energy, emerging markets, commodities, high yield debt, REITS or energy to name a few.
The satellites are a good place to rely on industry expert fund managers. A fund manager may have decades of experience evaluating a sector or country. This can be place to seek alpha -- or outperformance.
I hope that is a decent enough description of how the Core and Satellites strategy can work for someone. There are no hard and fast rules, but it does provide an overall framework to work from. If you have questions, let me know.
Diversification. You've undoubtedly heard the word. You probably even know what it means, and in what context it gets used most often. Yes, diversification is used most commonly when speaking about investment strategies.
So in the previous post, we discussed a rough approximation of how you can get to $10 Million in savings. The ways we can drive revenue to put into our savings account will be discussed in future posts, and mainly focuses around developing passive income strategies. But it is also important that we know how we will be deploying that passive income in our savings vehicles.
That is where the concept of diversification comes in. As much as we'd like to find one stock that will go up 10,000% in the next 20 years, there is almost an infinitesimally small likelihood we will be able to do that. Unforeseen events and competitors make that unlikely. It's more likely that something bad will happen to the stock over that time span, and we will lose a chunk of our investment. That is why we diversify. It is a much better idea to spread our risk over various stocks and asset classes, and simply count on the benefits of capitalism, economic growth, and interest rates to help us in the right direction. So spreading money across many stocks can help prevent the fallout if one stock fails. But what about market-wide, or sector-wide declines, like the '00 Internet Bubble/Crash, the '14-'15 Oil Crash and the '09 Housing/Financial Crisis? How do we mitigate their affects? The same way we do for an individual stock. We diversify across different sectors and different asset classes.
What does that mean? It means that you don't put all your money in one stock, and you generally don't put all your savings in only one type of stocks. You spread it between big and small stocks, growth and value stocks, US and international stocks, bonds, REITS, commodities, cash, etc.
What does this diversifying do in a nutshell? It lowers the correlation within your investment portfolio. That means that one component does not act like another. If one sector like Retail stocks goes down, another like Utilities, may do better. If stocks as a whole under-perform, bonds may be more likely to outperform. If stocks go down, real estate may keep going up. These aren't certainties of course, but we seek to hold assets that react differently to different situations.
There are long run benefits to this as well. We don't just do it to protect our money. It acts to increase returns in the long run. For example, ETF.com wrote an article on correlation and has an illuminating quote:
"The most dramatic impact in the portfolio comes when adding commodities as the seventh asset class. This multi-asset portfolio was comprised of large U.S. equities, small U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities—each asset class having a portfolio weighting of 14.3 percent. The seven-asset portfolio had the highest return (11.25 percent), the lowest standard deviation of return (8.67 percent), the lowest aggregate correlation (.128), the smallest maximum one-year drawdown (-10.2 percent) and a zero frequency of a 10 percent loss (as measured by IRR) over one-, two- and three-year periods. (The -10.2 percent maximum portfolio drawdown is, by necessity, calculated differently than IRR).
... The key point here is that highly diversified portfolios with low aggregate correlation tend to avoid losses, which essentially negates the need for a high recovery probability. In sum, the probability of recovery from a 10 percent loss within three years is slightly lower in the more diversified portfolios, but the frequency of 10 percent or higher losses is nearly eliminated."
So there you can see the benefits of lowering correlation by diversifying among asset classes, sectors, and definitely beyond individual stocks. We minimize huge losses, and therefore don't have to do as well to recover.
Did you notice something else? Just by diversifying between these asset classes, we have almost achieved one of our goals of 11.5% annual returns (see our second blog post). This is the number that we needed to achieve to reach our $10 million dollar goal!
So there you have it. A diversified portfolio is essential to reaching our goal, so is there any other reason not to do it? Tune in next week for further discussion on Asset Class Allocation.
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