Investing 101: Part 2

By December 22, 2018News

Investing is a tool for building wealth, but it is not only for the wealthy. Anyone can get started on an investing program, and various vehicles make it easy to begin with small amounts and add to a portfolio periodically. In fact, what differentiates investing from gambling is that it takes time—it is not a get-rich-quick scheme.

This tutorial will help you to understand what investing is, what it means and how the “miracle” of compounding works. It will also cover some of the building blocks of the investing world and the markets and provide some insights into techniques with the goal of helping you think about which investing strategies and vehicles are right for you.

When you are finished with Investing 101, you can continue your financial education with some of our specialized tutorials such as the Stock Basics or Mutual Fund Basics. You can also visit our website to ask one of our participating financial advisors any specific questions you may have.

Investing 101: Portfolios And Diversification

An investment portfolio is a collection of investments. Ideally these investments were chosen to work in harmony to help the investor achieve their goals and also to provide a certain degree of diversification so that you are not putting all your eggs in one basket.

An investment portfolio is a combination of asset classes such as stocks, bonds and cash. The portfolio might be further divided into sub-asset classes like large cap stocks, mid-cap stocks, small cap stocks and international stocks. On the bond side you might have some short-term bonds, intermediate-term, tax-exempt municipal bonds and foreign bonds.

Each asset class and sub-asset class can be further sub-divided.

Investment vehicles used might include mutual funds, ETFs, individual stocks and bonds and others.

You might view all of your investment holdings across various types of accounts as a single overall portfolio, or you might segment certain portions of your holdings as separate portfolios. For example your account for college savings might be one portfolio and the money earmarked for retirement might be managed as another.

Ideally a portfolio consists of a variety of investments, not all of which are highly correlated to each other.

Let’s look at a simple example using three Vanguard index mutual funds:

Vanguard Total Stock Market Index – A market cap weighted fund replicating the total U.S. stock market.

Vanguard Total Intl Stock Index – A market cap weighted index fund covering non-U.S. developed and emerging market stocks.

Vanguard Total Bond Market Index – A market cap weighted fund largely replicating the U.S bond market.

Over the five years ending February 28, 2017, these funds were correlated to each other as follows:

Vanguard Total Stock Vanguard Total International Stock Market Vanguard Total Bond Market
Vanguard Total Stock 0.79 -0.12
Vanguard Total International Stock Market 0.79 0.08
Vanguard Total Bond Market -0.12 0.08

A correlation of 1.00 between two investment vehicles mean that their performance is perfectly tied to each other, while a correlation of zero means there is no relationship between the two investment vehicles being compared. At 0.79, the Vanguard Total Stock Market fund and the Vanguard Total International Stock Market fund are highly, but not perfectly, correlated.

But a correlation of 0.08 between the Vanguard Total Bond Market Fund and the Vanguard Total International Stock Market fund means that there is very little relationship in the performance of these two funds.

The correlation of -0.12 between the Vanguard Total Bond Market Fund and the Vanguard Total Stock Market Fund means that there is actually an inverse relationship.

Here is a look at the risk and return of three portfolios using combinations of these three funds. These results are provided by a hypothetical portfolio tool.

The simulation assumes:

  •         Investments were purchased on 4/29/1996 with results through 2/28/2017.
  •         The portfolio was rebalanced back to the original allocation semi-annually.
  •         An initial investment of $50,000.

Conservative 40/60

  •         Vanguard Total Stock Market 30%
  •         Vanguard Total International Stock Market 10%
  •         Vanguard Total Bond Market 60%

Moderate 60/40

  •         Vanguard Total Stock Market 45%
  •         Vanguard Total International Stock Market 15%
  •         Vanguard Total Bond Market 40%

Aggressive 80/20

  •         Vanguard Total Stock Market 60%
  •         Vanguard Total International Stock Market 20%
  •         Vanguard Total Bond Market 20%

Here are the comparative results for these model portfolios:

 

Growth of $50,000 Cumulative % return Loss in Value 2008 (%) Loss in Value 2002 (%) % of variability in return compared to S&P 500 (last 10 years) % of modeled return compared to S&P 500 (last 10 years)
Conservative 40/60 $193,435 286.87% -14.03% -2.26% 44.25% 72.80%
Moderate 60/40 $211,527 323.05% -22.78% -7.81 63.86% 78.19%
Aggressive 80/20 $222,267 344.53% -31.02 -13.56 84.84% 80.81%

As you would, expect, the conservative portfolio had the smallest loss in 2008 of 14.03%. This compares to a loss for the S&P 500 Index of 37.00% that year. As you would also expect, this portfolio had the smallest rate of growth over the time period with an ending value of $193,435.

The aggressive portfolio had the largest decline of the three in 2008 with a loss of 31.02% for the year. This portfolio had the largest increase in value over the period with an ending value of $222,267.

The point is that combining different investments in various allocations will have an impact on both the growth of your portfolio and the downside risk over time.

Investing 101: Conclusion

Through the various sections of this tutorial, we’ve introduced and discussed a number of investing concepts and investing vehicles. Among them are:

  •         Stocks
  •         Bonds
  •         Mutual Funds
  •         Passive index mutual funds and ETFs
  •         Active management
  •         ETFs
  •         Real estate and alternative investing
  •         The importance of diversification
  •         Compounding and the benefit of starting early
  •         The concept of building a diversified portfolio
  •         Correlation between different investments
  •         Investing expenses
  •         The impact of technology on investing
  •         Robo advisors

Moreover, we stressed the idea that investing is not one size fits all. Different strategies work for different investors and different situations. Additionally, an investor might employ more than one strategy, or choose a variety of investment vehicles depending upon their goals.

Have a plan and a strategy

Just like going on trip in your car, it is important that investors have a plan and a destination in mind before investing their money. Your goals—whether planning for retirement or buying a home—dictate your time horizon, which dictates your tolerance for risk. Additionally, you want to make sure that you diversify your investments so that some do well when the rest of your portfolio might not. This approach allows an investor to construct a portfolio that is in line with their risk tolerance and that balances potential return with some downside risk protection.

Hopefully our tutorial has provided some insights and good ideas as you invest for your future.

Your journey is just beginning, however. Your challenge is to keep learning and stay informed.

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