Lots of people suffer from irrational fears. Claustrophobia, or the fear of being in small closed spaces and coulrophobia, the irrational fear of clowns, are my top two. I manage by generally avoiding elevators and clowns and more specifically, clowns in elevators. While this may seem unreasonable to some, I often hear people who have similarly irrational thoughts about investing.
Usually the conversation starts along the line of, “Is it possible my portfolio could go to zero and I would lose everything?” The standard answer is, ‘yes, it is possible, but should a properly diversified portfolio go to zero; there are many more things you’ll need to be worrying about at that time.’ So, the fact is that it is possible but it is not very probable and therefore something you shouldn’t spend a lot of time fretting over.
But what IS diversified portfolio? Generally, it consists of three basic asset classes: stocks, bonds and cash. Stocks, or equities, are ownership in a company or companies. By purchasing shares in a company, you are purchasing a partial ownership of it. That’s why you get those proxy statements in the mail asking for your vote on things prior to the company’s annual meeting or in the case of its purchase or its acquisition of another company. Corporate bonds, or fixed income assets, are basically loans you are making to a company or entity. Treasury Bonds (or Notes) and municipal bonds are loans to political entities, such as a bond for a university or to help finance our national budget. When you purchase a bond, the company (or governmental entity) promises to pay you a fixed amount of interest for a fixed period of time, then return the original amount of the bond to you at the end of the term. Cash or money market funds are exactly like they sound like; they are generally quickly available and carry very little risk, but they generally offer very little return as well. In some cases, especially with cash assets, they may be insured up to a set amount
Once the proper allocation between the asset classes is determined, the portfolio is structured among different mixtures within each asset class. For stocks, the common allocations are large cap or blue chip stocks, midcap, small cap and international. Large, mid and small cap refer to the capitalization or size of the company. Allocations for bonds can be corporate, governmental or municipal. The stock portion of the portfolio can be broken down further into different sectors such as pharmaceuticals, consumer staples, communications and beverages just to name a few. Likewise, the bond portion can include long term bonds, short term bonds, high yield bonds and tax-exempt bonds. The key is having portfolio that is properly allocated to achieve the results you require.
The actual allocation depends on your risk tolerance, your age, years until retirement and so on. Early in your life, you might tend to be more aggressive and carry higher weights (percentages) in equities and less in bonds and cash. Over time, or as you near retirement, the percentages may change. You can even allocate along a more risk to less risk scale within categories such as having some high-tech stocks as well as more traditional blue chip stocks. The point is, your allocation should not be a static percentage over time and should be analyzed to ensure your asset mix, both within and among your categories, changes along with your needs. Your investment advisor can assist you in evaluating your risk tolerance, your goals and your needs.
Another important factor to consider in your diversified portfolio is the impact of world events. While these can have an effect on a portfolio, it is rarely long lasting. Remember Y2K? Think back to the days after September 11, 2001, when things looked very dire. By October 1, 2001 the S&P index had fallen to 1,077. As I write this, it now stands at 2,435. And remember the Great Recession? It occurred during that same time frame. The index, which has recovered a good bit since 2001, fell back to a low of 805. The point here is that it didn’t go to zero. In fact, if you’d stayed the course, you wouldn’t have lost any money. Instead, you would have made a very nice return over that period. Never turn a temporary decline into a permanent loss by hasty reactions to such events.
Proper diversification and the wherewithal to withstand difficult times can address the fear of losing all your investments. There is probably a lesser chance of the market going to zero than of being trapped in an elevator with a clown, so you’ve got that going for you.