How to protect your money from the unexpected when investing
Diversification for Poor People: Reducing Risk
by Gary Foreman
You're beginning to save a little money. You'd like to put it into the stock market. What's your biggest fear? That the market will crash two days after you've made your investment! And it could happen. It's not very likely, but it's still possible. And more importantly, there's no one who can tell you for sure that it won't happen.
So how do you invest your money and still protect it from the unexpected? You use one investment to protect another. It's one of the major advantages of diversification. Let's see how it works.
Suppose there were a serious drop in the stock market. Many investors would want to sell their stocks. But, they need to put the money they get from selling somewhere. The most likely place to reinvest that money is to buy high quality corporate or US Government bonds. Why? Because they're safe in recessionary times.
You can use this information to help you. If you own both stocks and bonds, a decline in the stock market will increase the value of your bonds. So what you've lost in your right pocket, you've gained in your left.
How about another example? Many of you are old enough to remember the inflation of the late 1970's. Prices went up one percent each month for awhile. That was a real tough time for people who owned longer term bonds. In some cases they had made a commitment to loan money out at 6 or 7% interest for years into the future. Yet, inflation was going up by twice that amount. So they were really losing 6% each year. Not a very good investment.
But those same years were great for hard asset investments. Real estate, for instance, went up with inflation. There was no better investment for that period. If your portfolio had real estate and bonds you came through that period without significant losses.
What's the point? The same circumstances that cause one type of investment to go down causes another to go up. So by owning both you have some protection against unexpected events. You don't need to be able to see into the future. A portfolio holding different types of investments is ready for any future event.
In our last column we discussed the different types of investments: stocks, bonds, hard assets and cash. The next logical question is how much of each should you own. And, unfortunately, there's no one right answer for everyone. But, on the other hand, it's not as if one answer is right and all the others are completely wrong. Even if you don't have the absolute best answer, getting close should still be good enough to accomplish your goals.
A good, basic cautious mix is: stocks 50%, bonds 25%, hard assets 10% and cash 15%. If you're younger than 50 years old you might want to have another five or ten percent in stocks. If you're retired you'd want a little more in bonds. Don't spend all your time trying to find the perfect blend. It's better to get started and then fine-tune as you go.
Some of you are probably saying, "I can save about $100 a month. How do you split that up four ways?" And you're right. It's hard to invest $50 in the stock market or $10 in real estate! That's where mutual funds come in. They are an excellent tool for the person who can afford to invest a little on a regular basis.
A mutual fund automatically spreads your investment around. If you have a stock fund, you don't own shares in just one company. You're diversified over a number of companies. The funds allow you to reinvest your dividends and provide some nice record keeping for you. And it doesn't take thousands to start. Many excellent funds allow for initial purchases of $100 and will allow you to add in very small amounts.
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There are a number of good mutual fund companies you can use. We won't get into selecting one here except to say that you'll want to check out each fund's performance over a period of time, the sales charges (if any) and the expenses incurred running the fund. You can find comparisons of funds in many magazines.
Look for funds that invest in the area that you want. For stocks you'll see names that include "growth" or "capital appreciation". Bond funds will often include "income" in their name. Hard asset funds will invest in gold, oil or real estate. And your money market fund is good for the cash portion. If you think a particular fund looks interesting it's not hard to find out more about it. The prospectus will tell you what type of investments are being purchased in the fund. Read the sales brochure or call the company's 1-800 number. The better funds will be happy to answer your questions no matter how dumb you might think they are.
So there you have it. The basic framework for a diversified investment portfolio for poor people. You can start with a small amount of money and still be protected from economic surprises. If you start now and add to your accounts regularly you'll see how quickly the money grows. Get started today. Years from now you'll be glad you did.
Reviewed February 2018
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Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. Gary is available for audio, video or print interviews. For more info see his media page.