This is the 14th article in a series that will discuss and explain basic investment concepts in hopefully an understandable and meaningful way. Whether you work with an investment advisor or choose to do your own investing, there are some things you need to know to be successful. Here is my take on what those things are.
What kind of investments should I use in my investment strategy?
Should I invest in individual stocks and bonds? No. Too much risk, and not enough diversification. There is one exception to this, and that is if you work for a company that has publicly traded stock. If you feel good about the future of the company, you may be able to invest in the stock at a discount through payroll. Or, you may be able to invest in some of the company stock in your 401k. As a rule of thumb, make sure that the stock you own comes to no more than 10% of your financial assets. If it is a larger percentage than that, you had better feel real good about the company’s future. Just ask yourself how your retirement prospects look if that stock goes to zero. Are you willing to risk that much exposure to the stock?
Most people should invest in either mutual funds or exchange traded funds. These are large pools of stocks and bonds. It is much less risky to own 500 stocks than one stock: if you have one stock at it goes to zero, you have a problem; if you have 500 stocks and one goes to zero, you won’t notice. What is the difference between a mutual fund and an exchange traded fund (ETF)? The differences are disappearing. General perception is mutual funds are actively managed and the managers are trying to beat an index that looks like the fund. For example, a blue chip stock actively managed fund tries to out-perform the S&P 500. Sometimes they do and sometimes they don’t succeed. General perception is that ETFs are passive investments that mimic a particular index. Passive management says that most active managers cannot out-perform their benchmark index because of the higher cost involved in active management. Just buy the whole index (like the S&P 500) and be done with it. Just own the whole market and be happy with a market return. The real issue here is active versus passive. Well, there are mutual funds that are passive and there are ETFs that are active. The distinctions are blurred and getting blurrier. In the investment world we just love to keep making new kinds of investments to keep investors interested and confused.
If you are managing your own investments, you are likely better off using passive, low-cost investments (funds or ETFs) that mimic common indices of stocks and bonds. Asset allocation strategies (those investment pies I discussed in my last article) were designed using common stock and bond indices. They generally will work better using passive investments. Besides, if you decide to use active investments, then you have to start researching managers and long-term performance. That is just one extra thing to do that you probably aren’t any good at. Why bother? Yes, well-chosen active investments may indeed outperform their respective benchmarks, but there is probably at least an equal chance that they will not. The other big plus for passive investments is that most are very low in cost, as they don’t have to pay people to manage the portfolio. Lower costs increase your odds of investment success, as they take less from your return than higher cost alternatives.
All articles in this series will be posted on my website www.McNamaraFinancial.com. If you have any question or comments I can be reached at mike@McNamaraFinancial.com. I promise I will respond.
Michael J. McNamara, Ph.D., CFP®
CERTIFIED FINANCIAL PLANNER™
Disclaimer: Any financial advice in this article is intended to be generic in nature. Readers should consult with their own financial advisors before implementing any advice or suggestions above.