The big question is: How do I decide which opportunities to invest God’s surplus in? You remember Rule #2 from a couple weeks ago. We don’t put all of it in one place. If you are young, if you are able to handle the stress of some risk, if you have some rather large investment objectives, if you have a significant surplus to invest then you may wish to allocate your assets 100% to investments in the ownership as opposed to the lending category. That is, 100% in the stock market as opposed to the bond market. If you are nearing that time in life when you will no longer be able to work of hold a job (not retirement), if you cannot afford to risk loss of value in God’s surplus and you tend to be a “nervous nelly”, if you rely on the earnings from investments for living expenses, then you should probably be invested primarily if not totally in the bond market.
Given a particular asset allocation choice, how then do we decide what investment opportunities to consider? We are still faced with the need to diversify and remember, not more than 5%-10% in any one company. That means you will need to be invested in at least 10- 20 different companies if you choose to go this particular ownership route.
For regular folks like us, maintaining an investment “portfolio” of 10-20 or more individual company stocks seems rather daunting to me. There are more than 7500 individual stocks to choose from for which daily price quotes are available. However, the diversification problem was solved to some extent way back in 1924 with the creation of the first “mutual fund”. A mutual fund is simply a company that hires a full time professional manager to pool the money of many individuals and invest the funds in stocks, bonds, and other securities according to specific guidelines. Mutual funds typically own the stocks of around 100 companies or entities. The idea of course is to spread the risk of loss so that when any one or two companies experience loss it has only a minimal effect on the overall fund. This is a terrific idea. However, there are more than 6000 different mutual funds to choose from and individual funds tend to focus on or specialize in particular market or industry segments. There are funds that specialize in large companies, middle sized companies, small companies, very small companies, energy companies, utility companies, health care companies, technology companies, etc. so you also need to be careful not to put all your eggs into one mutual fund basket either. Mutual funds have much to recommend for themselves and Austin Pryor’s book lists 20 advantages of mutual funds.
We still haven’t determined how to make individual investment decisions and I know this is starting to sound scary. If you have decided to hire someone to do it for you I guess you can just stop reading at this point. However, I am going to argue pretty strongly now for doing it yourself.
- Information. First of all, you have virtually all the same information available to you that financial professionals have: books, websites, magazines, data, etc. The only problem is that there is a huge amount of information available and just sorting through it to determine what’s relevant and what’s not takes time. The professionals who work for large organizations may have access to other employees who specialize in doing some of this sorting for them. They may also have computer models and the like available to them but I’m not sure that’s always an advantage.
- Difficulty. This is not rocket science. If you will do the reading and research necessary to educate yourself you will find that much of this is just common sense. Some of the decisions will become mechanical with very little actual thought required.
- Help. Even if you don’t hire a professional to do it for you, professional help is available at relatively low cost. Some financial professionals specialize in research and analysis and publish their work and even make recommendations in subscription based newsletters and websites. I subscribe to one such service and the total annual cost is less than $200.
- Time. Obviously there is a learning curve if you decide to do it yourself. However, once you are “up to speed”, it doesn’t have to take a huge amount of your time. Just remember, even if you hire someone else to do it for you, you will have to spend a certain amount of time to provide personal information/data and to consult with your advisor. It takes me about 8-10 hours a month to do my own investing.
- Results. How well do you want to do with your investment of God’s surplus? Certainly you want to be rewarded for taking more risk than that associated with CDs or money market funds. You want to BEAT THE MARKET don’t you? Or would you be satisfied if you did as well at THE MARKET. Only about 15% of the “professionals” beat the market, so the odds of you doing it on any kind of consistent basis are slim to none. However, you can do as well as the market, guaranteed. Most mutual fund companies have at least one fund that exactly tracks a market index like the S & P 500 or the DOW, etc. so if you invest in one of these funds, you will realize exactly the same results. Now the only problem with this is that there are times when you don’t want to follow the market index. You remember last week’s chart showing a decline in the S & P 500 from March of 2000 to October of 2002 of almost 50%. When I say that 85% of the professionals didn’t do that well, it means their investments lost more than 50% during this period. Doing better than the market during this period means losing less than 50%. NOT A GOOD THING in any event. We will discuss three possible solutions to this problem next week.