Friday, February 10, 2006

Making Sense of Investing: A Guide to the Essentials


Whether you are a new investor, or an experienced investor looking for a way to make sense of it all, this guide is for you. The guide will introduce you to a comprehensive investing strategy you can understand and put together step-by-step.

The Guide Will Enable You To:

Implement the five essentials of investing
Understand and manage risk
Evaluate and select mutual funds
Recognize and control the devastating effects of cost
Develop and write an Investment Policy Statement
Evaluate and choose an Investment Advisor
Locate a large collection of reference material


CHAPTER 1: The Five Essentials

CHAPTER 2: Develop An Asset Allocation Plan

CHAPTER 3: How Diversification Works

CHAPTER 4: Diversifying A Portfolio With Asset Classes

CHAPTER 5: Costs are a BIG DEAL

CHAPTER 6: Building Your Portfolio - A look at the Options

CHAPTER 7: Rebalancing

CHAPTER 8: Formalize Your Investment Plan

CHAPTER 9: On Your Own Or Hire An Advisor

CHAPTER 10: Final Thoughts, References, Glossary


Many thanks to Jan Marks, Bob N. and Tim Wright for their invaluable help. Thanks to the Vanguard Diehards for helping me make some sense of it all. Special thanks to Taylor Larimore for his tireless assistance to others. And finally, thanks to Bill Schultheis, Larry Swedroe, Rick Ferri and all authors and contributors who are giving us the investing education we never had, and never knew about.

The comments button can be found at the bottom of Chaper 10


In the past thirty years, there has been a dramatic shift in retirement funding. An employee could go to work for a company and remain there for an entire working career, and on retirement receive a monthly pension and health benefits, and no worries about the future. That system was called a defined benefit plan. The system now in place is called a defined contribution plan.

In the old system your retirement plan was administered by your company. You didn't have to worry about learning how to save and invest because making sure there was adequate funding was your employer's concern, not yours. All you had to do was put your time in 'til retirement, then sit back and collect your checks.

In the new system, the plan is administered by a third party, but you, the employee, are responsible for funding it. Now you not only have to set aside part of your current income for retirement, you also have to learn how to invest it. Otherwise you risk not having enough money when you retire.

Unfortunately, our educational system has not kept pace with the changes in retirement funding. Investing fundamentals are not taught at the high school level as they should be, and even college does not address investing fundamentals unless you take an economics course. When it comes to knowing what to do, you're pretty much on your own.

Depending on where you work, your defined contribution plan might be called a 401(k), 403(b), 457, or something else. The numbers refer to the part of the IRS code that covers the plan regulations. Although your employer may match all or part of your contribution amount, you probably won't receive the information you need to get the most out of your retirement plan.

What little education you're given comes from those selling the product.

Many plans are provided by insurance companies that charge very high fees and offer poor fund choices. Others have more reasonable fees and better choices, but that doesn't help much if you don't know how to use them.

The challenge before you is clear: you must make retirement savings a top priority and take charge of your future by becoming an educated investor.

A General Perspective on Saving and Investing for Retirement

While this book is about investing, a few comments about saving are in order because the two are so closely tied together. Before you can invest, you have to save. Your investment money can come from money you have put aside in your savings account, or it can bypass that and simply go directly to an investment from your wages. Saving is the real key to future wealth. No one is going to make you save, but no one is going to hand you a nice check every month after you retire either.

For some of you, serious saving may require a new perspective. Think for a minute about why you work. The answer is easy because the goals are readily apparent – you work so you can provide the necessities for yourself and your family, and earn enough to enjoy a better life.

Now, you have to add another goal that isn't quite as apparent: saving for a better life when you stop working. Saving for something so far away doesn't seem too important because more immediate goals appear to take priority. But preparing for that time is a very big part of your job now. You can't afford to ignore it.

Where do you think your income will come from after retirement? It will come from the money you have saved and the money you have invested. You have to save (pay yourself enough while you're working) to be able to support yourself after you no longer receive a check from someone else. Want to pay yourself well and enjoy a comfortable retirement? Then you have to continuously save and invest a portion of your earnings. With each paycheck, pay yourself first. Do it automatically and you won't even miss it.

How much will you need for your retirement nest egg? The general guideline is that you need to set aside 25 times the amount you plan to withdraw each year. This amount has a high probability of lasting 30 years without reducing the original principle.

This is where investing comes in. To accumulate what is needed is going to require higher returns than you can get by simply saving your money in a bank. Investing in the stock market has provided those higher returns. In addition, you want to start as early as possible in order to have the power of compounding those returns work for you.

The stock market has provided higher returns than savings accounts and bonds, but the reason is there is more risk involved. And the risk does show up—Investing is a bumpy road. Individual companies can go bankrupt and the stock market as a whole can crash as it has done several times. Also, the stock market can go a decade or more without providing the expected higher returns. It is important to understand this so you can make intelligent decisions about how much of your savings you are willing to expose to stock market risks.

The probability that the businesses you buy will reward you in the future is high. The value of all companies (the stock market) has an upward slope over time, but no one can guarantee the market or your investments will provide what they have in the past. On the other hand, you have to take some market risk to have a good chance of reaching your goals. The need to have enough money for retirement offsets the risk you have to take.

Remember, you'll need to accumulate total assets of about 25 times what you intend to withdraw in retirement. So, if you want to retire with an income of $40,000 a year at age 62, you need to accumulate one million dollars (today's dollars).

Assuming an average annual return of 8%, here is what you need to save each month starting at different ages in order to draw down that $40,000/year. Note that the 8% used is an attempt to represent a portfolio of approximately 75% stocks and 25% bonds. Since future market returns are unknown, the 8% and the associated savings/investing rates should be viewed only as an example. Actual returns will vary.

Beginning at age 22, you'll need to save $300 per month.
Wait 'til age 32, and you'll need to save $670 per month.
At age 42, you'll have to save $1,800 per month.

The catch is you can't get an 8% return on your money if you put it into a savings account. In the above example, if you start saving at age 22 but only earn a savings account rate of return, instead of $300, you'll have to set aside $1,000 per month. That's over 3 times more than if you invest some of your savings in the stock market. Also notice that waiting until age 32 requires you to save more than double the amount of age 22. Waiting until 42 requires six times the amount. These big increases are due to the power of compounding investment returns over longer time periods.

But wait, using the 22 year old as an example, what if it said instead of making 1 million over that 40 year period, you could make an additional $400,000 more using the same mix of investments, but with one very small adjustment—earn 9% instead of 8%. Wow, who would settle for 8% when they can get 9%? Well, many investors do exactly that. The adjustment needed to get the 9% is in the cost you pay for investing. It goes like this: no one actually receives all of what the market returns because you lose what you pay in costs. You can't control what the market returns, but you can control costs and there is a proven relationship between the costs you pay and the returns you get. If you pay 1% higher costs, you lose 1% in returns. And over time, that 1% can cost you $400,000.

The example demonstrates four things:

1. The need to take some stock market risk.
2. The big advantage of time and starting to save at a young age.
3. The power of compounding returns.
4. The relentless stranglehold costs have on returns.

Nothing can be guaranteed—risk is real. Smart investors do not forget this. And that is why they use every means at their disposal to minimize the elements of risk by investing in the most efficient way. The idea is to get the maximum return for the amount of risk taken and each dollar spent. Or actually, for each dollar unspent. That is what this book is all about.


In the coming pages, you will be introduced to an efficient, comprehensive and easy-to-understand investing strategy that is proven and backed by academic study. Over longer periods of time, this strategy will provide you with higher than average returns without large commitments of time or study. The fundamentals in this guide are relevant whether you use active funds or index funds.

The secret to investing and achieving higher than average returns is simply the elimination of mistakes most investors make. The stock market provides returns everyone hears about, but the truth is that investors as a group net substantially less than those returns.

With the aid of this guide, you will learn how to protect yourself from throwing away returns due to behavioral mistakes, unnecessary costs, and the more serious risk of bad advice. If you are considering an advisor, or already have one, you should find chapter 9 on evaluating and choosing an advisor very helpful.

The investment guide begins with an examination of the risks associated with investing. Then we move on to creating an investment portfolio that targets your goals and matches your desired risk exposure. And finally, in chapter 8, we cover the differences between active funds and index funds and how to use them in the most effective and efficient ways.

Throughout the guide you will find many links to additional information that you may want to explore. A glossary of investment terms is provided along with many additional links and references in the final chapter.

No matter if you manage your own investments or decide to hand the job to someone else, understanding essential investing principles is a must. With this book as your guide, you will gain the knowledge needed to learn and apply these essentials.

Taylor Larimore, Dean of the Vanguard Diehards as Money Magazine has named him, and one of the three authors of "The Bogleheads' Guide to Investing", has summed up the secret of successful investing in one concise sentence: The best way to beat the average investor, professional or otherwise, is to save regularly, avoid mistakes, keep your costs low (including taxes), diversify, and stay the course. The sentence is a true investing "gem."

Best wishes as you begin your journey along the pathway to investing success!

Wednesday, February 8, 2006

Chapter 1
The Five Essentials

Making Sense of Investing
It is understandable that beginners find the subject of investing daunting and confusing. Where do you start? Are there guidelines? How do you make sense of it all? In addition to newer investors, there are also millions of people who have been investing for years and they still have an uneasy sense that they don't have a compass. There is so much information out there, but oddly, looking to Wall Street provides no answers.

What’s traditionally been drummed into your head is that investing is very complicated and should only be attempted by professionals or with the aid of very expensive and risky strategies and software programs. Don’t buy it. Investing doesn't need to be complicated.

The portfolio selection method, as we will call it, provides investing with structure. It enables average investors to implement the method step-by-step. The know-how of a Wall Street analyst isn't needed to understand it or use it successfully, nor is the ability to analyze and select individual stocks.

If it’s so easy, then why haven’t you heard of it before?

Wherever money is involved, there are people who want a share—and on Wall Street, it is your money they want to share. Simply put, it is extremely difficult to find someone from a large, mainstream investment firm that will level with you on your best investment options. They need to sell you expensive products that make their firm money because they are employees and that’s their job. So, what you really need to learn is what Wall Street doesn't want You to know, which also happens to be the title of a very good book by Larry Swedroe.

Here are the five investing essentials necessary to successfully use the portfolio investment method:

1. Define your goals, set targets, and decide on an asset allocation that fits your needs. Asset Allocation is simply the percentages of your money you plan to place (allocate) into stocks, bonds and cash. It determines most of your investing risk.

2. Diversify your holdings. Diversifying means placing some money in different kinds of investments in order to spread your risk.

3. Keep costs as low as possible. Whatever you spend on buying and maintaining your investments comes directly out of the returns you receive.

4. Rebalance your portfolio when necessary. Rebalancing is simply readjusting your allocation percentages back to where you originally set them so you can maintain your chosen exposure to risk.

5. Formalize your investment plan. Developing a plan and then writing it down is a way of demonstrating your commitment. It also serves as a compass to insure you stay on course.

The following chapters will explain what the essentials are and how they work with each other to create a portfolio with maximum benefit.

For those who like the technical stuff, here are two links offering an excellent introduction to the portfolio selection method.1

Note 1. Harry Markowitz, "Portfolio Selection," 1952

On to Chapter 2.

Chapter 2
Develop an Asset allocation

in line with your risk tolerance.

Asset allocation (AA) is a financial term that simply refers to what percentage of money you decide to put into stocks, bonds and cash—the primary asset classes. It is the most significant decision regarding risk and potential returns you can make.

Before you make the decision about your asset allocation, you need to know what it is exactly you are trying to accomplish. No, to grow your investments as much as possible is not the right answer.

You begin by defining your goals and the target amounts needed as best you can. Younger investors may have several goals they’re working toward such as retirement, college for the children, and a new home. Each of these goals has a different time frame and a different target amount of assets needed. And each requires a different asset allocation.

Since asset allocation is all about risk management, that’s where we will begin. The more you understand about risk, the more able you will be to make good decisions about asset allocation and the more you will understand about investing in general.

This link to Vanguard’s How to Create Your Investment Plan will help you get organized.

What is Risk?
There are a few different ways in which risk is measured and discussed, but we will start with this definition: The risk of putting your money into stock investments is that it may not be there for something important when you need it.

The higher percentage of stocks you own, the higher your potential for big returns. But risk is a double-edged sword. Risk means in no uncertain terms that you might not achieve those big returns, and you may not have the money when you need it. Investing offers no guarantee, otherwise there would not be any risk.2 Knowing this, smart investors always seek a good balance between risk and potential reward.

Asset Allocation and Risk
Jack Brennan, former CEO of The Vanguard Group and author of Straight Talk on Investing has this to say, "The very first step in assembling an investment portfolio is to decide how to spread your dollars among stock, bond, and cash investments--Spend a lot of time on this decision--it is the most important one you will make."

Controlling risk and maximizing potential returns for the chosen level of risk is the goal of your overall investment strategy. When making the choice of an AA, you have to seriously consider each goal, it’s time line, and how much you are depending on the money being there.

Your decision on how much risk you are willing to take is a personal choice. That’s why one recommendation for how much stock to own should not be suggested to all investors. Don't compare your allocation to those of others, it isn't relevant. Risk management is as much a personal behavioral issue as it is a calculated assessment of need and willingness.

This link leads to a good article on risk by Pete Bernstein.

Here is a good perspective on how risk should be approached by Zvi Bodie, professor of finance, and Paula Hogan, CFP, CFA.

Emotional Temperament and Risk
Newer investors often overestimate their tolerance for risk. That has been clearly confirmed by the number of investors who abandon their asset allocation and bail out of stocks at the bottom of a bear market.

Here is what Vanguard has to say:
Our experience suggests that even long-term investors pay attention to short-term downside risks during the holding period. Furthermore, their real-time reaction to downside risk is much more significant than indicated prior to the realization of the downside risk.

So, how much of a loss is really going to keep you pacing the floor at night? How much of a loss is going to make you flinch?

What makes investors flinch?
1. Inexperienced investors move into defensive mode under stress and fall back on gut instinct, which quickly overrides the AA decision they made in good times.

2. Perception of risk is not constant. Risk may be perceived to be practically non-existent in good times and extremely high in times of market stress or personal emotional stress. If you have not been through a full market cycle, including a bear market, it will be very difficult for you to properly asses your reaction in times of real stress.

3. Choosing an asset allocation seems so simple to do that it's often done without much planning. After all, you just have to pick a number. And with many newer investors, that’s exactly what they do. Investors making the choice of an AA in good market conditions often tend to focus only on returns. They don’t see any risk. And that’s a point worth remembering—if you can see the risk, then it really isn’t a risk because you can take measures to avoid it. No, risk is all about surprises that can spoil the party.

So, what should you do? First, realize that your assumed tolerance level is likely to be lower under severe market conditions when it’s most important. Second, focus on your goals and your plan and set up asset allocations that match them. If you get that right, then you will find it easier to stick with your plan.

Risk Analysis Questionnaires
Some investors who talk with an advisor are given a risk analysis test. Others might be referred to web sites that have questionnaires designed to help choose an allocation. These can be helpful, but often investors fail to get a full appreciation for the impact that market risk can deliver.

Here is what William Droms, CFA, and Steven Strauss, CPA/PFS, had to say about questionnaires in an article in The Journal for Financial Planning titled "Assessing Risk Tolerance for Asset Allocation: "Virtually all experienced financial planners and investment managers would agree that a questionnaire by itself cannot possibly lead directly to a definitive asset allocation plan."

The biggest problems with questionnaires are that they either ask you how much risk tolerance you have, for which you have no reference to determine, or they attempt to quantify your need for returns and then offer a portfolio without consideration for your emotional risk tolerance.

The level of risk you choose should be based on factors including age, job type and security, marital status, contingency plans, back-up resources, and several other possibilities. Then these factors have to be balanced against your emotional tolerance for risk. If your needs don’t match your tolerance, you are likely to dump your strategy at the worst possible time.

Here are two links to questionnaires. But don’t take questionnaire recommendations at face value. It is possible to score high on risk tolerance and not be suited for high risk because of your personal circumstances. Consider the questionnaires as just one part of your overall assessment.

Vanguard Questionnaire:

Rutger’s Questionnaire:

Basic Market Behavior and Risk
To help understand normal market risk, let’s look at typical market behavior.

Here is what William Coaker, CFP, CIMA, says you will encounter in your investment journey: Investment professionals often tell clients, "I think the S&P 500 will be up 10 percent next year," and clients like to hear that. But it almost never happens. From 1926 to 2004, the S&P 500 rose between 8 percent and 14 percent in only six years, an 8 percent occurrence. In fact, just 25 times in 79 years the S&P 500 returned between 0 percent and 20 percent, which is only 32 percent of the time. That means the index has been more than twice as likely to lose money or gain more than 20 percent than to experience returns between 0 percent and 20 percent.

The first thing to note is markets are volatile and you cannot expect things to go smoothly, nor can you rely on past behavior as a predictor of future behavior. Normal markets are random and unpredictable in the shorter term. And contrary to popular belief, they are not less risky in the long term.

Jack Duval, Registered Investment Advisor has this to say in his article, The Myth of Time Diversification: the idea that the longer an investment is held, the less likely it is to produce a loss. It is an idea that enjoys wide circulation on Wall Street. It is wrong.

A Look at Historical Market Losses - Downside Risk
You can get a fair perspective on risk by looking at actual stock market losses compared to how much money was allocated to stocks.

The table below is based on actual market losses (price) encountered in the brutal 1973-74 bear market. A bear market is normally defined as a market decline of 20% or more. Drops of 10% to 15% are called corrections.

Note in the table that a 100% stock portfolio lost nearly 50% of its value in two years. If you had 50% stocks and 50% bonds, your loss would have been limited to 20%.

Max Equity Exposure....... Max loss

80%.................................... 35%
90%.................................... 40%
100%........................... ...... 50%
Data provided by Author Larry Swedroe on Morningstar's Vanguard Diehard's Forum

On average, a bear market has occurred about every 5-6 years.

Here are two links to historical bear market data

When you have many years to go until you need the money and you have a reliable income, larger percentage losses may be tolerated. When your time-line is getting close, retirement for instance, you will want to reduce your allocation to stocks to reduce the risk of loss.

The Highly Improbable
Author Larry Swedroe likes to remind us to never confuse the highly improbable with the impossible.4 What Mr. Swedroe means is that over a lifetime of investing one or more extremely remote possibilities may occur and you should not dismiss the possibility of such events as if they were impossible.

So, you have to consider the "highly improbable" when building your portfolio. The risk of a worst-case scenario is real and should be respected—it can happen when you least expect it.

While the stock market has provided far greater returns than any other investment class, the ride is a bumpy one. If you don't wear a safety harness, you may get hurt.

Making Up A Loss
Another way to help you decide on an asset allocation and risk level is to look at how much you have to earn to make up for a loss. Here is a table that shows the required gain for a given loss. Notice the make-up rate is not linear. The higher the loss, the higher the required gain to get even.

Loss (%)....... Req'd Gain
5%................. 5.2%
10%................. 11%
15%................. 18%
20%................. 25%
25%................. 33%
30%................. 43%
35%................. 54%
40%................. 67%
45%................. 82%
50%............... 100%

As you can see, a 50% loss from an all stock portfolio required a 100% gain (it needs to double), but a 20% loss, which would equate to a portfolio of 50% stocks and 50% bonds, only required a 25% gain. As Terry Savage notes in her book, "The Savage Truth on Money," "Getting even with the bear is tougher than getting ahead." What Ms. Savage is saying is it is much easier to moderate a major loss than try to make up for one.

To take this one step further, let’s look at what happens to two portfolios, one 100% stock (investor A) and one 50% stock (Investor B). Let’s assume each is 10 years from retirement and each has accumulated $600,000 in assets.

If a severe bear market occurred, investor A’s portfolio would drop to $300,000 and Investor B’s would drop to $480,000. Investor A must now double his assets—a 100% return—to get back to where he was before the bear. At the historical rate of return of 10.4%, this will take him 7 years.

Investor B only needs a 25% return to get even again. With an 8.4% return—the historical return of a 50/50 portfolio—he can do this in 3 years. Recovering losses may not take as long as these example because in many cases substantially higher returns were generated in market recoveries. But quicker recoveries can’t be relied on if your future goals depend on the money being there.

One thing to note in these examples is that when the AA is reduced from 100% stocks to 50% stocks, the returns don’t get reduced by half. See 'model portfolios on Vanguard's website.

When assessing your risk, consider your ability, willingness and need to take the risk. A younger investor will have more ability and may have more willingness if he has a secure job and a regular income and is continuously adding to his investments. He also has more need. Young investors need to grow their portfolios with a larger allocation to stocks.

Ultimately, your asset allocation should be based on your entire financial situation. For instance, an older investor who has a pension or other steady income plus his investments has some stability and therefore may have some ability to take additional risk. A retiree depending only on withdrawals from his portfolio may not.3 Most retired investors need to think in terms of asset preservation with larger allocations to bonds.

Author Larry Swedroe, in his book, The Only Guide to a Winning Investment Strategy You'll Ever Need suggests you not develop an asset allocation in isolation. You need to thoroughly review your financial and personal circumstances. Consider things like your need for cash reserves, job stability, job correlation to the economy and the stock market, investment horizon, insurance, estate planning, and back-up resources.

Jack Bogle, former CEO of The Vanguard Group and author of "Common Sense on Mutual Funds" says it clearly: "Choose a balance of stocks and bonds according to your unique circumstances—your investment objectives, your time horizon, your level of comfort with risk, and your financial resources."

Suggested Allocation Ranges
The stock exposure an investor can choose ranges from 0% to 100% of course, but there are some guidelines. Young, inexperienced investors believe that with time on their side they can go 100% in stocks. And some retired investors believe they don't need and don't want any stock at all. Neither of these extremes seem to be a very good choice.

Legendary value investor Benjamin Graham recommended holding no more than 75% stock and no less than 25%. William Bernstein points out in his book The Four Pillars of Investing that a portfolio with 80-85% stocks and 15-20% in bonds and cash reduces downside risk to a significant degree while hardly reducing returns at all. Here are the numbers. Please note that the returns used are historical. Future returns may be lower. Potential losses, however, are related to asset allocation and not returns, so they would remain about the same.

If you think about this for a second, you will realize that the lower the expected returns, the less incentive there should be to take the risk of very high stock allocations. There is less on the up side without a reduction on the down side.

Average Annual Return 1960-2004
100% Stock Portfolio = 10.6%
80% Stock, 20% Bonds = 10.1%

Loss in 1974 Bear Market (Worst Year Loss)
100% Stock Portfolio = -28.4%
80% Stock, 20% Bonds = -22.7%

On the other end of the spectrum, having no stocks at all exposes older investors to no growth, which may mean faster drawdown of their portfolios. Also, having 15-20% stock and the rest in bonds and cash actually provides little or no additional risk and better returns. Here are the numbers for the reverse portfolios of 100% bonds and 80% bonds and 20% stock:

Average Annual Return 1960-2004
100% Bond Portfolio = 7.2%
80% Bonds, 20% Stock = 8.1%

Loss in 1969 (Worst Year Loss)
100% Bond Portfolio = -8.1%
80% Bonds, 20% Stock = -8.2%
Data from Vanguard

One last note on choosing an allocation: Kahneman and Tversky discovered in their research study5 that a loss of $1 is approximately twice as painful to investors as a gain of $1 is pleasant. Why? The gain is expected, anticipated, and exciting. But the loss is not only somewhat of a surprise, it is a setback and may be seen as failure of the plan. People do not like losing their hard-earned money.

E. F. Moody, CPA clarifies this in his online article "Risk and Other Stuff About Investing: Though rarely commented upon, recent studies show that investors are not necessarily risk adverse as much as they are loss adverse."

Frank Armstrong, CFP, author of "The Informed Investor," likes to say "The impact of asset allocation on investment policy swamps the other (investment) decisions."6

You have just covered the first essential. Asset Allocation is the main risk management tool in any kind of investing. It is the shape of your portfolio framework. Take a rest and let this brew a bit so you can connect the idea of risk to your own tolerance level and how it will be integrated into your asset allocation.


2. Vanguard Group study, "Use Asset Allocation to Build a Better Portfolio, 2003."
3. Frank Armstrong, Investing During Retirement, Part II Constructing the Investment Policy,
4. Larry Swedroe, from the book, "What Wall Street Doesn't Want You to Know."
5. Daniel Kahneman and Amos Tversky, “Prospect Theory”, 1981
6. Frank Armstrong, "Investment Strategies for the 21st Century", Ch.6, The Asset Allocation Decision,

Chapter 3
Chapter 3 Diversify Your Holdings

Diversification - A simple explanation; Spreading your money into many broad areas is called diversification and it works something like this. Let's say you are packing for a trip to a place you’ve never been and you don’t know what the weather will be like. What do you do? You pack a variety—some light clothes, some heavier ones you can layer, and finally a coat. You want to be prepared for any kind of weather. You are reducing the risk that you won't be prepared, no matter what. You do the same thing with your investments because you are investing in the future - a place you’ve never been and where you can never be sure what awaits you.

Diversifying in the market
Before you can substitute market diversifiers for clothes you need to understand some basics about how the stock and bond markets are organized.

Part I. Market Basics

The Stock Market
The stock market is exactly that - a market for shares of about 7200 publicly owned businesses of all types and sizes. To organize the market, the companies are divided by size, represented by their worth, into large, medium, and small sized companies. Company size is also referred to as market capitalization (market cap).

Market cap is all the shares of a company times the price of the shares. All of the buyable shares are owned by all investors, so the market actually works much like an auction with the sellers trying to get the highest price and buyers trying to get the best deal.

From the view point of investor money, market organization can be thought of in terms of where that money is invested. For instance, if you invested $1.00 in the total stock market, almost three cents would go into one stock, GE, one of the largest companies in the market. Less and less money would be allocated to all the other stocks as they got smaller, but each would receive an equal amount according to their worth.

The top 10 companies represent about 18% of the entire market capitalization. In other words, 18% of all investor's money is in those top 10 stocks. The top 25 stocks represent almost a quarter of the whole market.

The stock market is generally divided up into three size categories; large capitalization (large cap), mid cap, and small cap. Different methods are used to categorize the size ranges. For instance, Morningstar defines large cap as companies with market caps above 10-11 billion.

Currently, General Electric has a market cap of a whopping $306 billion. Other companies in the top ten are giants like Microsoft, Exxon Mobil, Walmart, At&T, and Johnson and Johnson.

Companies with market caps between 10-11 billion and 1.2-1.8 billion are classified as mid size. Some companies currently in the top 10 mid-sized category are MEMC Electronics, US steel, Noble Corp, and Smith International. Small size companies have market caps below about 1.2-1.8 billion. Companies currently in the small cap category include Priceline, FMC, Cabot Oil and Gas, and Reliance Steel and Aluminum.

Indexes have been created to track the whole market as well as various segments of it. The Wilshire 5000 is one index that tracks the whole market, but the Standard and Poors 500 (S&P 500) is the best known index and it is used as a benchmark for overall market performance. The S&P500 tracks the largest 500 companies in the market, but because of the market cap weighting, those 500 companies represent about 70% of the whole market.

The S&P500 follows the total market’s movements very closely. The 500 stocks in the index contain all the market’s large cap stocks, those with market caps above 10-11 billion, and about half of the mid cap stocks, those between 10-11 billion and 1.8 billion. The remaining 6700 stocks in the total markets are the rest of the mid caps and all the small caps. As you can see, there are many more small stocks than large, but in investor’s dollars or market movement, they don’t have much impact. They make up only 30% of the market’s overall capitalization. This weighting makes the market look like an inverted pyramid with large boulders on top, some pebbles in the middle, and grains of sand at the bottom.

In addition to the three size separations, the market is also divided into value stocks, growth stocks and those somewhere in between, which are called blend. There are various measures used to indicate whether a company is a value type company or a growth type company.

So now we have nine "boxes" that segment the market: Large value stocks, large blend stocks, and large growth stocks. Then the same three separations for mid and small stocks. Incidentally, the S&P500 and the Total Stock Market indexes fall into the large blend category because they are dominated by a broad spectrum of large cap stocks. Table 1 shows the holdings of the S&P500 as defined by Morningstar (5/08).

Table 1
Composition of the S&P 500

Large Value

Large Blend

Large Growth

Mid Value

Mid Blend

Mid Growth

Small Value

Small Blend


Compare this to a profile of the total U.S. stock market (7200 stocks).

Table 2
Composition of the Total Stock Market

Large Value

Large Blend

Large Growth

Mid Value

Mid Blend

Mid Growth

Small Value

Small Blend

Small Growth

Some market segments act differently enough from one another or the overall market that they are called different stock asset classes. For instance, small value stocks as a group do not follow the movements of the large blend group.

Large value (LV), Large growth (LG), Small value (SV) and Small growth (SG) are like different kinds of clothes and are called asset classes for purposes of diversifying stock. These sub asset classes are just for stocks and should not be confused with the primary asset classes of stocks, bonds and cash discussed in the asset allocation section.

In addition to the four classes of stock mentioned, international stocks and REITs (Real Estate Investment Trusts, pronounced Reets) are also well recognized asset classes because they too act quite differently than the total U.S. stock market. There are other groups as well that some investors consider classes, but you can do very well with just those I’ve mentioned. Asset classes are the real key to diversification Owning two mutual funds in the same asset class does not increase diversification.

Major Stock Asset Classes
Large value
Large blend/growth
small value
small blend/growth

The Bond Market
Like diversifying with stock funds, it is also wise to diversify with bond funds. Bonds are loans called debt instruments (DI). There are a large variety of them and they are categorized by type and quality. There are government treasury bills, notes and bonds, state bonds, municipal bonds and corporate bonds of short, intermediate and long maturity. There are treasury inflation-protected bonds (TIPS), tax-deferred bonds (I-bonds) and low-quality bonds know as hi-yield or "junk" bonds. When you purchase a bond you are essentially loaning money.

There are two main concerns with bonds or bond funds: one is quality, and the other is duration. As with stocks, quality and risk are intertwined.

Treasury bonds are backed by the U.S. government and carry no loss of payment risk. Corporate bonds are issued by companies seeking needed money. These can be of very good quality or very risky. Lower quality equals higher yields and higher risk. Companies in poor financial shape have to offer higher interest rates or no one will loan them money, but the higher interest comes with the risk of the company failing to return the loan. Each bond has a quality rating and each bond fund has an average rating. Hi-Yield funds carry mostly all higher-risk low-quality bonds that are often called "junk bonds." Limit your riskier bond fund exposure to 10%-15%.

The other consideration with bonds is the duration. The price of a bond, once issued, goes up or down depending on interest rate changes. Duration provides a sensitivity measurement for how much the price might change with rate changes. The longer the duration of a bond, the more the price will fluctuate with interest rate changes.

Link to Vanguard Interest Rates and Bonds

The price of a bond already on the market fluctuates to keep the older bond competitive with new bonds that have different rates. For instance, the price of a 10 year bond that pays 4.0% will go down if a new 10 year bond comes out paying 4.5%. This is because no one will buy a bond paying 4.0% unless they can buy it at a discount. Bonds with higher rates are issued when the borrower can't find enough investors to loan money at lower rates.

Longer term bonds have higher yields, but they also have higher durations, which makes them more volatile than short and intermediate term bonds.

A bond fund has a mixture of many bonds maturing at different times so funds use an average maturity of short, intermediate or long term. And each fund will also have a duration. Durations range from about 2 for short term bonds to 8 or 9 for long term bonds. A fund with a duration of 4 means the fund’s net asset value (NAV) will go down 4% for each 1% interest rate increase and it will go up 4% for each 1% interest rate decrease. Inflation-protected bonds have a built in component that moves with interest rate changes so it protects the bonds from being worth less because of inflation.

Link to Morningstar bond tutorial -

Link to Treasury Inflation Protected Securities (TIPs) tutorial -

General Investment Risks
In finance, risk has a number of different meanings. We have already examined the most basic definition in the asset allocation section - the chance the money won't be there when you need it. A second type of risk is called specific stock risk. If an investor holds a high percentage of his money in one stock he holds a high risk of losing a lot of money if something goes wrong with the company. This type of risk is about a small chance of a major catastrophe. Something like your house burning down.

The chances of a fine company going bad is small, but if it happens, and it does occasionally, the consequences will be big if most of one's money is in that stock. This type of risk can be eliminated by holding many stocks, and that is one of the reasons for holding mutual funds. It’s kind of like fire insurance. In a fund of 100 stocks, one company crashing doesn't create much of a ripple.

Be careful about putting too much into the stock of the company you work for. Most recommendations say to limit investments in one stock to no more than 5%. You might be able to stretch this some, but don't ignore the long-shot possibility of unseen risk.

Additional discussion on risk

Part II. Diversifying Your Investment Portfolio With Asset Classes - the core of the portfolio selection method.
Once you have set your overall asset allocation—the percentages in your portfolio assigned to stocks, bonds and cash—you can turn to diversifying your equity holdings with the sub asset classes of large value, large growth, small value, small growth, international and REITs.

Diversifying with these different asset classes can provide some reduction of a third kind of risk called volatility.

Volatility is a risk which measures how much a fund’s returns might fluctuate. It is technically defined as standard deviation (SD). And standard deviation is a mathematical risk factor used for tracking the swings in returns for stocks, bonds, and funds. The bigger the SD number, the larger a fund's returns may fluctuate.

Volatile Assets in a Portfolio
Portfolio volatility reduction occurs because the returns of the different asset classes do not move together. They do not correlate with each other. Combining asset classes with different volatilities has the effect of lowering the volatility of the overall portfolio.

Graphic illustration of volatility and correlation.

But diversification does something else that is quite remarkable: it can increase your returns given the same amount of volatility risk.

As Larry Swedroe remarks in his book, "What Wall Street Doesn't Want You to Know “Diversification of risk through the ownership of low-correlated assets is the only free lunch in investing."

In the following example, 30% of small international is added to the S&P 500 and the overall volatility (SD) of the portfolio is lower than either of the two asset classes alone. And the returns are improved by 2% over the S&P500 alone.

Example of asset class diversification:7


Asset class Return SD
S&P500 10.8% 17.5
Small International 15.0% 30.1
Mix 70 S&P/30 Int. 12.8% 17.2

The S&P500 is a large blend/growth asset class and small international stock is a class of stock that doesn't act like the S&P - It doesn't correlate with the movements of the S&P500. In fact, one may be going up while the other is going down—that makes it a good diversifier.

Small international is very volatile on it’s own. In statistical terms, the SD of 30.1 means that in any year the annualized returns of 15% might be anywhere between +45% and -15%, 67% of the time. The other 33% of the time the swings can be much more, even twice as much.

In practical application, standard deviation (SD) can be viewed as a measure of unpredictability. in short time frames, the returns can vary widely. For instance, small international could have two or three years with returns of +35%, but in the year after you invest the return could be minus 10%. This is one reason why you should never invest in a fund based on passed returns. And the higher the SD of a fund, the more unpredictability and the less you should hold.

When investors diversify properly, one of two of their asset classes might be down at any given time while others are doing well. But which asset class might be favorable in the market changes from time to time and those changes cannot be predicted. This is like changes of weather on your trip. But if you are diversified, you will have a much better chance of having something in your portfolio that is outperforming.

Eric Tyson says in his book, Mutual Funds for Dummies "To decrease the odds of all of your investments getting clobbered at the same time, you must put your money in different types or classes of investments."

Let’s try one other example, this one with REITs. Data from 1972-2003

Portfolio 1
Stocks 50%, Bonds 40%, T-Bills 10%, REITs 0%
Return = 10.9%, SD = 10.8%

Portfolio 2
Stocks 45%, Bonds 35%, T-Bills, 10%, REITs 10%
Return = 11.2%, SD = 10.4%

Portfolio 3
Stocks 40%, Bonds 30%, T-Bills 10%, REITs 20%
Return = 11.5%, SD = 10.1%

Notice again that the returns go up and the standard deviation goes down.
Data provided by T. Rowe Price Investor Magazine June, 2005

There you have it, the magic of asset class diversification in action. It is the different correlations interacting together that make it work. Correlations between asset classes are always changing to some degree due to different market forces, but that's not something to be too concerned about. In the example above, the percentages of REITs won’t always give the listed returns and SD, but you can be sure diversification will be working at some level as long as you don’t add too much of the more volatile asset class.

Link to a good article demonstrating the positive effects of diversification

On to Chapter 4.

Note 7: Paula Hogan, CFP

Chapter 4
Diversifying a Portfolio with Asset Classes

Diversifying a Portfolio with asset classes
A good approach to diversifying with stock asset classes begins with viewing the U.S. equity portion of a portfolio. The total U.S. market profile is about 72% large cap, 19% mid cap, and 9% small cap (refer to the table on market organization in Ch. 3). Using this profile as a gauge gives you something to use as a comparison for your own individual portfolio holdings. Getting too far out of line with the market profile by adding a very large portion of one asset class may cancel the benefits of diversification and actually add additional volatility (SD). It will also introduce something called tracking error.

Tracking Error
Tracking error occurs when a portfolio that is much different from the market profile is used. Such a portfolio will not follow the movements or returns of the total stock market.

A non-conforming portfolio will at times have higher returns than the market, but it will also have lower returns at times. Inexperienced investors are quite pleased if their portfolio is beating the market, but many simply cannot stand to see the reverse. Having a portfolio that is down when the market is up causes many investors to abandon their strategy and change things, which hurts returns.

Portfolio Examples
The following portfolios are typical examples of those used by many investors, but they are not recommendations. What I'm trying to show is the process of developing a risk-controlled portfolio structured with recognized asset classes. It will be up to each individual investor to define their own risk profile and portfolio.

One of the simplest ways to build a portfolio is to use a mutual fund that tracks the entire market. A total market fund provides a lot of diversification because it has large cap value and growth stocks plus mid and small stocks in the exact proportion as the market. To further diversify, an investor should next add a total international fund. Usual recommendations for international exposure run from 20% to 40% of the equity allocation.

In the following examples all fund holdings add up to 100%. That is one recognized way of listing a portfolio. Viewing all accounts as part of the whole portfolio helps you get an overall view of everything you own. It also enables you to put assets in the most advantageous places.

Sometimes allocations are separated into percentages of stocks and percentages of bonds. Be sure you are clear on which way a portfolio's holdings are being presented or recommended.

In the following example, total international is 20% of the equity allocation. Equity is 60% of the portfolio and 12 is 20% of 60.

Total U.S. Market Fund
Total International
Bond Fund


This simple equity allocation contains all the major stock asset classes except REITs.

William Bernstein writes in is book, The Intelligent Asset Allocator, "If over the past 10 or 20 years you had simply held a portfolio consisting of one quarter each of indexes of large US stocks, small US stocks, foreign stocks and high quality US bonds, you would have beaten over 90% of all professional money managers, and with considerable less risk."

If you wanted to add REITs, recommendations for allocations usually run from 5% to 15%. Although REITs are U.S. equities and mostly small and mid cap stocks, they are not considered in the market profile because they don't act like any other asset class, and the market does not contain a significant amount of REITs.

In many cases an investor may not have access to total market funds, especially in tax-deferred accounts through work or at various brokerage houses. When that occurs, a S&P 500 fund or a large blend actively managed fund would be a good choice. If an investor uses one of these choices, she might add a small cap fund. Then the portfolio might look like this:

Large Cap Fund
Small Cap Fund
Total International Fund
Bond Fund


Here is example that includes all the asset classes:

Large Blend or Growth Fund
Large Value Fund
Small Cap Fund
Small Cap Value Fund
International Fund
Bond Fund


You could add a mid cap fund in the mix too, but mid caps aren't considered the best diversifiers because they act a lot like a combination of large and small. However, they can provide better-than-average returns at times.

Bond allocations
The fixed income portion of your financial assets is the safe part of your portfolio. It has been described as a portfolio's belt and suspenders.

Bond funds are great diversifiers and the main controller of overall portfolio risk management.

Like stock investments, bond investments do not have to be complicated. One typical bond portfolio in a tax-deferred account might look like this:

Total Bond Market Fund
Inflation-Protected Securities (TIPs)
Hi-Yield Bond Fund


It the example above, there is a total bond market component which covers many kinds of bonds and provides lots of diversification. The TIPs component will add an inflationary hedge. And finally, there is a higher-risk/higher return component in hi-yield bonds. You don’t want to add too much of a riskier component like hi-yield because the first purpose of bond holdings is to moderate risk, and there are times when hi-yield bonds can act much like stocks. For this reason, there are a few experts you do not recommend hi-yield bonds.

Bonds in a taxable account might look like this:

Limited Term Tax-Exempt Bond Fund
State Tax Exempt


When using taxable accounts, it's best to go with tax-exempt or tax-deferred bond funds or taxes will eat up much of the return.

The cash portion of a portfolio might consist of money market funds, CDs, stable-value funds, and savings accounts. Putting all three primary asset classes together results in a full portfolio that looks like this:

Example of a diversified Total Portfolio: Stocks = 65%, Bonds=25%, Cash=10%. Note at all funds add to 100%

Large cap value fund - 16%
Large cap blend or growth fund - 16%
Small cap value fund - 6.5%
International fund - 20%
REIT fund - 6.5%

Bonds = 25%
Total bond fund - 15%
TIPS - 7.5%
Hi yield fund - 2.5%

Cash = 10%
Money Market - 5%
CDs - 5%

Other examples—You add the allocation appropriate for your situation.

Taylor Larimore’s Thrifty Three
Total Stock Market
Total International
Total Bond

Rick Ferri’s Core Four
Total Stock Market
FTSE All-World ex. U.S.
Total bond

More Examples -

Here are a few final thoughts on asset classes. Historically, over long time periods, value stock and small stock asset classes have produced higher returns than the overall market.8 Some investors deliberately overweight these classes. If you consider something like this, remember that you will have higher tracking error and the results may not be see immediate results.

Note 8: Larry Swedroe, "Explaining the Value Premium," 2/2002,