In June the financial advisors at Ruedi Wealth Management wrote another round of short “Investing 101” columns that appear every Sunday in the News-Gazette’s Business Extra section.
Make sure to look for them every Sunday, but in case you missed them this past month, below are the Investing 101 columns from June.
Dollar-Cost Averaging
Paul R. Ruedi, CFP®
Investors who have a lump sum to invest in the stock market often face a dilemma. They know they need the money to be invested and participating in the growth of the stock market, but are concerned they will invest at just the wrong time, right before the stock market tanks and takes their account balance with it. It can be tough for investors to balance the need for stock returns with the fear of regret, and the idea of investing all of their money at once and putting it at risk can simply be too much for investors to handle. This often causes people to delay investing indefinitely and miss out on the returns they need.
Fortunately, a process called “dollar-cost averaging” can help investors overcome this fear of regret by investing only a portion of their money at a time over a specific period instead of all at once. Instead of investing 100% of their money right now, an investor who chooses to dollar-cost average may invest 10% of their money each month over the next 10 months, or 25% of their money each quarter.
There is no specific length of time that will work for everyone; investors can choose whatever works for them. This is not an all-or-nothing decision either. Investors may choose to invest half of their money now and dollar cost average the rest.
Investing a smaller portion of their money can often be easier for investors to handle emotionally than investing all of it at once and can keep them from putting off investing indefinitely. If the temporary decline the investor was worried about does actually show up, they should take some comfort that they were not fully invested.
Since the stock market rises slightly more often than it falls based on daily trading data, investors who dollar-cost average are likely to “miss out” on returns relative to investing all of their money right now. But the ability to have at least some money invested where there would otherwise be none is a huge benefit when the market rises.
It is essential for investors who choose to dollar-cost average create a plan for how they will ultimately become fully invested over time and stick to it. It could be very tempting to an investor who started dollar-cost averaging to become scared and stop investing halfway through the process. If investors aren’t sure if they can follow through on their plans to become fully invested themselves, they may want to enlist somebody else to keep them accountable for doing so.
Rebalancing
David Ruedi, CFP®, RICP®
Investors targeting a certain asset allocation (mix of stocks to bonds) will notice that over time as different parts of their portfolio grow at different rates, their allocation will drift from its original target. To bring their investments back to their target percentages in their portfolio, investors may have to do some buying and selling, a process called “rebalancing.”
The purpose of rebalancing is to maintain your targeted level of risk and return. For example, if an investor started with a $100,000 portfolio of 50% stocks and 50% bonds and stocks experienced a 30% rally while bonds, for the sake of example, go nowhere, stocks would then make up 80k/130k or 62% of the portfolio. In this case, an investor would need to sell stocks and buy bonds to return to their target allocation of 50% stocks and 50% bonds.
The opposite could also happen. If a huge stock market decline were to occur, stocks would decrease in value and make up less of the portfolio, and investors would need to sell bonds and purchase stocks to return to their original target.
Investors may wonder how often to rebalance, and there is not necessarily a right or wrong answer. Rebalancing every day would be unnecessary, as you would be constantly buying and selling based on the short-term movements of the stock market with little impact. But waiting too long to rebalance could see your portfolio drift to a level of risk you may not be comfortable with.
Instead of focusing on rebalancing over specific time periods, it may be more helpful to rebalance once a portion of your portfolio has drifted a certain percentage from its target weight. You may choose to rebalance every time a position drifts more than 5% away from its target weight, or something similar.
It’s impossible to determine what rebalancing strategy will be optimal going forward. The important thing is to have explicit rules for rebalancing. Don’t rebalance based on hunches or market forecasts. . Rebalancing can be difficult for investors emotionally because it generally involves selling investments that have been performing well and buying investments that have been performing poorly. If you do not have the discipline to stick to a specific rebalancing plan, you may want to seek the help of a professional.
What to Expect When You’re Investing
David Ruedi, CFP®, RICP®
If you’re going to be a successful stock investor, you must stay invested at all times. This sounds simple, but it’s not easy. There will be periods of time that stir up emotions and create a strong desire to change your portfolio. But if you know what to expect, you can avoid surprises and you’ll be less prone to making emotional decisions that sabotage your investment results. So, what should you expect when you’re investing?
The first thing you should expect when investing in stocks are temporary declines. Market declines are an inevitable part of investing and they happen on a regular, although unpredictable, basis. In fact, almost every year contains a “correction” (defined as a decline of 10% or more). Most people aren’t too bothered by these corrections; it’s usually “bear markets” that cause problems. Bear markets are defined as declines of greater than 20%, but they have averaged closer to 30%. Historically speaking, they have come along about every 5 years, though they can be more or less frequent.
The second thing you should expect are long periods of treading water. Although the market has a positive expected return over long time horizons (decades), investors need to expect extended periods of little to no growth in their portfolio. The most recent example is what pundits label “the lost decade,” which represents the period between January 1, 2000 and December 31st, 2009. A dollar invested in the S&P 500 at the beginning of that time ended up worth 91 cents at the end. This is an extreme example using only one asset class, but the principle still holds: there are going to be extended periods where your account balance doesn’t grow.
If you’re a diversified investor, you should expect your investment performance to differ from common investing benchmarks. The most common benchmarks for the stock market are the Dow Jones Industrial Average (DJIA) or the Standard & Poor’s 500 Index (S&P 500). But, if you’re a truly diversified investor, this is an apples-to-oranges comparison. The DJIA and S&P 500 represent one asset class: large companies in the United States. If your portfolio includes multiple asset classes, I can promise you your portfolio will perform differently than the benchmarks you see on TV. Sometimes you will do better and sometimes you will do worse.
Last but not least, you should expect to be rewarded for staying invested for long periods of time. If you control your emotions and stay invested through the difficult periods I’ve just described, you can expect to grow your wealth substantially.
Diversification
By Paul R. Ruedi, CFP®
Diversification is the process of spreading your money around to many different investments.
Investors intuitively know the danger of “putting all your eggs in one basket.” Should an investor decide to invest all their money in a single investment, if something terrible happens to that investment, it will take all their money and financial goals down with it. Investors should avoid putting too much of their money in investments in a single company, industry, or country for this reason.
An equally important benefit of diversification is that it ensures you own whichever investments happen to be the star performers at any given time. The performance of the stock market as a whole is driven by a relatively small number of the best-performing stocks; the only reliable way to ensure you will own these companies at any given time is by owning all companies all the time.
From a more technical perspective, diversification allows investors to do the equivalent of financial alchemy: reduce portfolio volatility without sacrificing expected return. In the late 1950s, Harry Markowitz produced research that showed that by building a portfolio of multiple investments that behaved differently from one another, an investor could actually lower the variability of their portfolio without sacrificing expected return. This research was so ground-breaking it earned Dr. Markowitz a Nobel Prize.
Today it is easy for small investors to spread their money around to many different investments. Investors can spread their money between thousands of companies around the globe using a single mutual fund or ETF. Bond funds provide a similar opportunity for small investors to spread their money around to bonds of many different companies, governments, and government entities.
People often wonder how many companies or different investments are required to consider themselves diversified, and there really isn’t a definite number but within reason, the more, the better. Since investors today have the opportunity to invest in thousands of companies around the globe and limit the impact any one company, country, or industry can have on their investment portfolio, why would you consider anything less to be fully diversified?
If you spread your money between thousands of stocks and bonds around the globe, the fortune of any one investment cannot materially impact your ability to achieve your financial goals. Diversification is extremely important to lifetime investors and retirees who depend heavily on their investment portfolios to fund their goals. If you are not sure if your portfolio is adequately diversified, make sure to talk to a financial professional who can help you determine if you are.