One of the strategies we follow in our financial planning is safe investments. However, investment is never safe. The question is how much risk we should take. Investment is not our main stream of income. We use it as a mean of savings. This is one of the reasons we take low risks in the area of investment. Another reason is, we are not experts; we are learning as we go.One feature that caught our attention while we were doing some extensive research on strategies for saving is the diversity in an investment portfolio.
The dilemma of which stock to own is somewhat addressed by diversification of a portfolio. The term diversification is widely used by financial advisors. We did not have much idea about investment and diversification until a few years back when we started to think about long term financial planning. As the term diversity figuratively suggests, a portfolio should have divergence from different angles. We will explain the details soon in this article.
Diversification may come from different directions in a portfolio. When I say portfolio, I mean a mix of funds. Diversification is necessary because we really do not know which company will perform well and which company will not do so well. Of course, market analysis and keeping an eye on the news help but the stock market is so unpredictable time-to-time that people doing a full-time job might not have enough time to check the funds and do a market research everyday.
People may be able to check the funds every month or sometimes every few months. We prefer a mix of companies or funds that are historically strong and steady. Investing most of the money in one company, even if the company has a great history, is not a good idea because the fate of a company may depend on many uncertain factors. It is difficult to evaluate the factors for ordinary investors like us. We try to maintain the following diversity features to be in the safe side of the equation.
The companies you choose must have some diversified area. For example, you can choose areas like entertainment, consumer products, service, technology, energy sector, etc. From each area, you can choose stocks of one or two companies. Some example stocks in the entertainment sector are Netflix (NFLX), Disney (DIS), and Lions Gate Entertainment Corp (LGF). Some consumer product stocks are Procter and Gamble Co (PG), CVS Health Corp (CVS), Coca Cola Co (KO), etc. Service stocks may have many categories like education and training services, consumer services, shipping services, advertising, publishing, broadcasting and many other service providing companies. There can be hundreds of companies under these areas. One may choose a few based on past histories of the companies.
One can easily find a few technology companies based on internet research. Some examples are Apple Inc (AAPL), Microsoft Corporation (MSFT), Google known as Alphabet Inc (GOOGL), and many other stocks. I do not know what category Amazon.com, Inc. falls into. It can be a consumer product company or it can be a service provider. It does not really matter. Amazon has shown steady growth over the past few years.
I am providing some examples NOT because they are good stocks but only as a reference to explain the categories. In practice, one needs to find out which companies she/he should invest in after doing a market research. Along with the growth history, profit is a parameter that one needs to analyze for diversification. I will talk more on this in a few minutes.
Diversity in mutual funds
A mutual fund is a mixture of stocks of many companies. I am providing an example of a mutual fund to ease the explanation: Fidelity’s Select Electronics Portfolio (FSELX) is a mutual fund. FSELX combines stocks of a number of electronics companies including Intel Corp, Qualcomm Inc, and Broadcom Ltd. Mutual funds need not be purchased in share units. That is, an investor does not need to purchase round number of mutual fund shares. If the price of a mutual fund share is $90, an investor may purchase 1.5 of this fund which will cost $135. This sort of purchase in fraction is not possible with regular stocks.
Anyway, a mutual fund itself creates a diversified portfolio since it combines stocks of tens of companies. The fortune of one company can make only a little effect on the price of a mutual fund. However, many mutual funds are sector based. That is, a number of companies are selected within a sector. For example, FSELX combines companies of the technology sector. As a result, all the companies within the mutual fund will tremble if the sector itself shakes for any reason.
The diversification in the mutual funds can be done by choosing funds from different sectors. Some example sectors are: Electronics, Retailing, Consumer, Health Care, Real Estate, Technology, Software and IT, Biotechnology, Transportation, Telecommunication, and many others. There are also Municipal and Government bonds that are composed as mutual funds. The basic idea is to make sure that the mutual funds one uses as investment must have diversified sectors.
Sometimes it becomes hard to diversify mutual fund investments from the very beginning of investment because there may be a balance requirement of a few thousand dollars. For example, FSELX has an initial investment requirement of $2500. One can keep investing smaller amounts in FSELX after the initial investment. To diversify a mutual fund account, one has to make multiple initial investments in a number of different mutual funds. It was not possible for us to do a diversification in one fine morning. Rather we slowly built a diversified portfolio of mutual funds over time. We are still in the process of diversifying our mutual fund account. We feel that it is better not to make any sudden investment with a desire to obtain a quick return.
Value versus dividend
Some stocks have proven themselves as value stocks where many others are known as dividend stocks. A value stock tends to increase in its stock-price over time. An example of a value stock is Amazon.com Inc. (AMZN). A dividend stock shows lesser tendency in increased stock-price, rather the trend is to generate steady or higher profit.
For a layman like me, dividend is a synonym of profit. An example of a dividend stock is Ford Motor Company (F). You will find that the price of a stock of Ford has not increased much in last five years but the company has managed to pay a steady annual dividend. Ford’s current dividend yield is 4.93%. One strategy of diversification is to make sure that a portion of the portfolio has some dividend funds. In sickness and in health of the stock market, good dividend funds will keep returning a percent of the investment.
Some financial institutions offer Dividend and Income mutual funds. As a part of our diversification strategy of mutual funds, we prefer at least one fund that leverages the power of dividends. The overall growth of dividend intensive mutual funds might be a little lesser than the mutual funds that mostly return based on the value of the underlying funds. However, the dividend funds are steady and seem to be less susceptible to market fluctuations. The frequency of dividend payment to shareholders vary between company to company. Some pay three times a year, some twice, and some just pay the dividends once a year.
There are several traditional indices (scores) that reflect the goodness/badness of the market. One such index is S&P 500 index. S&P 500 is the abbreviation of Standard & Poor’s 500 score. This is a stock market index computed based on the market capitalizations of five hundred large companies. The companies are listed on the New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotations (NASDAQ). The equation to compute the S&P 500 index is not a subject of this article but the basic idea is that the index expresses how well the market is doing. A higher S&P value indicates a better market, indicating that stock prices are increasing. In Google search, if you just write S&P 500 Index and hit enter, you will be able to see a curve reflecting the fluctuation of the index over time. You can change the timeframe (day, week, month, year, five-year, etc.) to get a feeling about the market in past times.
Every company and all fund managers try to (and many times struggle and fail) to maintain a growth rate higher than the growth rate reported by S&P 500. The basic idea is to be able to say this: My company or my mutual fund is doing better than the average of the top 500 companies. The historic data of s&p 500 is impressive. S&P 500 index was around 1100 five years ago. It is above 2180 as of today. That means, if someone had a mutual fund that mixes S&P 500 companies in the ratio used to compute S&P 500 index, the person could double her/his money in five years. Although not every five year is the same but historic data suggests that long term S&P index is quite promising.
There are mutual funds that follow the proportions of stocks in S&P 500 index. These funds are called index funds. One way of extreme diversification is the use of index funds. Another good thing about index fund is that its annual fee is very low because the fund manager only needs to maintain the ratio of the stocks of the top 500 listed companies. The basic objective is already given. A portion of a family’s mutual fund investment can be some kind of Composite Index Fund. As an example of an index fund, Fidelity has an index fund called Nasdaq Composite Index Fund (Symbol: FNCMX) that follows the NASDAQ composition.
The market fluctuates throughout the entire year. The prices of stocks and mutual funds change everyday, more or less. Our observation is that it is not a good idea to invest all the intended savings at the same time. If someone starts with $20,000, it is better to invest it slowly over time, may be in a year or so. By time diversity, we refer to slow investment. The basic idea is to diversify (spread) investment over time.
It would be the best if an oracle could tell us when a stock price would be minimum and when it would reach its peak. In that case, we could buy the stocks when they are inexpensive and sell them when they are over-priced. Unfortunately, the success rate of stock market oracles is not that impressive. Therefore, it is better to keep buying throughout the entire year slowly, steadily, and frequently to make sure that an average buying price is obtained overall.
Diversity through periodic investment
This is basically another form of time diversity. Invest everyday, if possible. If not, invest every week. If that is not possible, invest every month. Make sure that a percentage of your paycheck regularly goes to an investment account. All investment accounts now-a-days have systems to set automatic transfer of funds from any bank to the investment company. We generally set up an automatic transfer on a certain day of the month and an automatic distribution of the transferred funds to multiple mutual funds.
Verify diversification periodically
You can come up with many strategies that you are comfortable with and suit your needs. The main idea is diversification of the investment portfolio. One thing we need to make sure time to time is that the diversification strategy used is still a valid one. For example, we may think that we have enough dividend stocks but over time the companies we selected for our dividend stocks might not be performing well to return the same rate of dividends. Or, the mutual funds we selected in the IT sector might be performing poorly because of worldwide go-green campaign (a hypothetical scenario). Checking all the funds periodically, a number of times throughout the year, helps in planning the family finance a lot.
We are currently comfortable with analyzing company stocks and mutual funds. As stated in our previous article regarding investment, we prefer to use transaction fee-less financial institutions for company stock investments. The reason is, fees are sometimes too large for small amount of frequent transactions. Transaction fee-less institutions like Robinhood generally do not have mutual funds because of their slim profit margin. Mutual funds are managed by an expert appointed by a financial institution. Example of financial institutions that have mutual funds are: Fidelity Investments, Voya Financial, Lincoln Financial Group, Vanguard Group, Prudential, and many other companies. Investors generally do not pay transaction fees for mutual funds but there is an annual fee which may be as high as 1%, or such. We must check if historic data suggests that the annual growth of the fund is higher than the annual fee.
We should read terms and conditions carefully before purchasing mutual funds (as well as stocks).
Financial planning of a family is a continuous process, not just an activity. The goals and objectives change over time. Example of different goals are: save for an emergency fund, save for down payment to purchase a house, save for college fund, send kids to college, plan for retirement, move investment portfolio to lower risk category as retirement nears, etc. Therefore all family leaders (dear wife and dear husband) need to stay on top of the analysis and planning.
Please let us know if you have any question or comments.
Note: We first published this post on August 9, 2016. We have re-published this after some updates.
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