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We talked about three basic principle of managing money last time. Assuming you have followed those and have gradually accumulated some assets and disposable income, it is time to think about investing, i.e. managing your assets.
“Which stock should I buy?”
“Which stock should I buy?” is perhaps the first and the most frequently asked question for people thinking about investing.
My advice is simple: Do not think about picking stocks. On the contrary, think low-maintenance.
The reason is simple: Stock picking is too time-consuming, and for most people does not pay. Let me elaborate a bit more on this point. In asset management there are three types of decisions that affect returns on assets:
Strategic asset allocation (i.e., how much money to put into different asset classes such as stocks, bonds, commodities, etc..);
Market timing (i.e., when to buy, and when to sell), and
Stock Selection
Which of the three do you think has the highest impact on your long-term return?
You might think stock selection has much effect, but it turns out that the first type of decisions, i.e., strategic allocation of assets, has the most impact. Marketing timing matters, but research has shown unequivocally that people are consistently bad at marketing timing (i.e. people are more likely to ‘Buy high and sell low’, a sure way to lose money).
Stocking selection has the least impact, and yet people spend the most time talking about which stocks to buy or sell. But the fact is there are many professional money managers out there whose full-time jobs are evaluating companies and selecting stocks. You are not going to beat them. So do not spend much time thinking which stocks to buy or sell unless you plan to be a professional money manager (A better question to ask yourself is perhaps: What does God want me to do with my time?).
Core Asset Allocations
Since asset allocation is the most important, let us take a close look at asset classes. The most common types of assets include: stocks (also called equities), bonds, real estate, commodities, etc. Stocks have higher expected return compared to bonds but also have higher volatilities. The expected return of the whole US stock market is estimated to be 7.5% annually for the next ten years, while the annual volatility of S&P 500 (a stock market index) is about 17.5% going forward.
In considering how much to invest in each class, these are the major criteria to consider:
What are their expected returns?
What are their risks (volatilities)?
What are their correlation among each other so that the aggregated risk can be reduced (i.e. diversification)?
How liquid are they, i.e., how easy is it to sell when you want to sell?
What are their expected cash flow?
These are tough questions, but the good news is that you do not need to make those decisions frequently. In fact, once you have decided on the major allocations, you only need to make minor adjustments along the way. A basic rule of thumb is 40% stocks, 40% bonds, 20% real estate. Or you can get more refined than that. For example, a sample portfolio may look something like this:
US equity 25%,
Foreign developed country equity 10%,
Foreign emerging market equity 10%,
Real estate trust 15%,
Inflation adjusted Bonds 10%,
Municipal bonds 30%.
If you want to be more conservative, you can then reduce equity holding and increase bond holding.
In the next installment, I will share with you some practical advice on how to build a low-cost low-maintenance portfolio.