Tuesday, March 3, 2009

Investment Pyramid: A Broad Base

Welcome to the second part of our week -long look at building an investment pyramid. Yesterday, I shared some advice to help secure your finances and get yourself ready. If you took all the steps I recommended, you are now in good shape to begin investing. But, where to start?

Your first steps into investing should be as broad-based as possible; the market can be volatile, and having wide-ranging holdings is the best way to minimize just how much risk you take on. In other words, diversify, diversify, diversify!

The best method to diversify your holdings is by using mutual funds. Mutual funds are essentially collections of investments, such as stocks, bonds, or other assets, that are held by the mutual fund company. The fund, in turn, sells shares to investors. Buying shares of a mutual fund gives partial ownership of all the assets held by the fund; if a mutual fund you invest in owns stock in one hundred companies, you will own a small portion of each of those company's stock.

At LEAST 70% of your investment money should be invested into broad-based mutual funds; if you're conservative or just don't want to be bothered with lots of research, you can go all in on mutual funds, and your investments will work out fine. There's no need to get any more complicated than mutual funds if you don't want; mutual fund companies make mutual fund investing complex enough already. There are thousands of mutual funds currently in existence, divided into numerous categories and groups based on what assets they hold. Some of the broad categories used by mutual fund companies are:

-US Stocks - One of the biggest and broadest categories is mutual funds that own stock (partial ownership stakes) in companies based in the US. There are numerous ways that these stocks are divided up: on the basis of company size, growth-oriented (that is, companies that are increasing in size) vs. value-oriented (companies that are selling for less than their intrinsic value), and those that are managed by humans as opposed to those that simply buy all the stocks in a particular index (called index funds, appropriately enough).

US Stock funds will typically form the bulk of your portfolio, especially if you're young. The growth potential of stocks is among the highest you can get from investments, and making sure your holdings take advantage of that growth will help to meet your investment goals. If you don't have the time (or the interest) to do in-depth study on the many, many US stock funds that exist, you can simply buy a total market index fund, like Vanguard's VTSMX, and essentially own the entire market.

-Foreign Stocks - There are companies located in countries other than the United States, of course, and foreign market funds invest in stocks based around the world. Frequently, these stocks are divided up based on the home country of the company (into European or Pacific Rim companies, for example) or how developed the country's economy is currently (into developed or emerging markets).

Foreign stock funds add more diversity to your holdings; if you're entirely in US stocks, troubles with the domestic economy could drop your portfolio, as well. Holding foreign stocks lessens (but, does not eliminate) the possibility of all your investments being down at the same time. Again, a broad-based, whole foreign market fund, like the VGTSX from Vanguard, provides an easy way to get your desired foreign exposure.

- Bonds are essentially IOUs, pieces of debt from companies or government that need to borrow money and agree to pay it back, with interest. They come in a variety of flavors, from US government bonds (Treasuries, essentially your own little piece of the national debt) and municipal bonds (used by cities to meet their expenses) to corporate debt. The latter is rated and grouped according to the estimated risk of default, and grouped into investment grade (the ones that are unlikely to default) and 'junk' (bonds that are quite likely to default, and thus pose a significant risk).

Bonds are primarily used to help stabilize your portfolio; because they aren't as volatile as stocks, holding a portion of your assets in bonds will tend to blunt the pain of downturns in stock prices. Unfortunately, the same holds true on the upswing; high bond holdings will limit how much your investments can grow. As a result, if you have a significant time before retirement, more than twenty years to go, for example, you're probably best served with an all stock portfolio. When you're approaching retirement, slowly adding to your bond holdings, in a short-term bond fund like VBISX from Vanguard, will cushion your portfolio and make your investment life a little less harrowing.

-Money Market - money market funds invest in short term debts, and offer fairly low dividend payments to their investors. They are designed to keep a stable price of $1 a share, and are considered exceedingly safe (last year, the Primary Reserve Fund created waves when it was the second money market fund in history to decline in value). These funds typically generate interest rates in the same neighborhood as that available from online savings accounts.

While you're young, money market funds are probably used for storing your emergency fund. They're very stable, but offer almost no growth; most of the time, you'll barely keep up with the rate of inflation. When you are approaching retirement, though, increasing the amount of money you have in ultra-safe investments will give you somewhere to start drawing the income you'll need in retirement. Having three or four years worth of expenses in a money market fund like VMMXX from, yes, Vanguard, will give you a nice cushion to wait out a market downturn, while limiting the need to sell your other assets until they recover.

Simple Mutual Fund Plan - If we put together all the features we've been discussing to this point, we can come up with a simple, fairly conservative investment plan for a lifetime. When you start investing, put 30-50% of your money in a foreign total market fund, the rest into a total US market fund. When you're about twenty years from retirement, start to transfer money (using new money as much as possible, to avoid selling off your stock funds) into a short term bond fund, increasing the portion of money in the bond fund each year. So, 10% in bonds with twenty years to go, 20% five years later, 30% at ten years to retirement, and 40% with five years before we get to retirement. With less than five years to go, start to add to your money market funds, building up a sizable cash cushion for when you need to start drawing down your funds, and you should have a smooth retirement.

That's essentially my plan for my investments (although, being the nerd I am, I couldn't resist complicating it just a bit). It's pretty simple, but the best plans usually are. If you do want to look into other investments, you're in luck: we'll be covering those in the next few days.

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