Ask the grumpies: How do you approach diversification?

Ali asks:

We are good savers but I fear not great investors (i.e., I have a good bit just sitting in the bank now because I don’t know what to do). How do you approach diversification?

Disclaimer:  We are not professional anything except academics.  Consult with a fee-only financial planner with fiduciary responsibility and/or do your own research prior to making major decisions about your money.

If you don’t know what to do and your money is just sitting in savings, the easiest thing to do is to pick out a retirement date (or house purchase date or whatever) and buy some of Vanguard’s target date fund for that year.  It will take care of diversification for you both right now and over time and you’re done.  (You can also mimic it on your own by purchasing the major indices in it.  Mimicking it will save you some money early on (far from the target date) when there’s not much movement because you’re not actually doing much rebalancing early on– you’re mostly in stocks.  It is still better just to buy the target date than to leave it in the bank trying to figure out how to mimic.)

Here’s #1’s original post about how she decided on percents in her retirement account.  They’re probably a bit conservative (too bond-heavy) for when she was younger, but are more appropriate now.  But #1 wasn’t trying to optimize– diversification isn’t about optimization, it’s about getting decent returns while still staying safe.  In fact,  diversification will always return lower than some subset of undiversified portfolios (it will do better than another subset though!).

Let’s step back a little bit an think about why we diversify.

Diversification is all about moderating risks.  We put some money in stocks, which are high risk/high return and some money in bonds which are lower risk/lower return because bonds keep their value in downturns while stocks are likely to lose value (but stocks shoot up high in up-turns while bonds… keep their value).  We keep some money in cash in the bank because it keeps its value and can be drawn on quickly in an emergency.  In general, we want money that we will draw on decades from now to be in stocks and money we will draw on within the next 5 years in something more accessible like cash or bonds.  The closer you get to your target date, be it retirement or buying a house or starting college payments, the more safe and accessible you want your money to be (with some disclaimers for college savings as where those are put can affect financial aid).

More advanced asset allocation will have you thinking about blue chips vs. tech stocks or emerging markets and international markets.  But the thing is, if you’re at the point where you’re not sure what to do with your money, you can just ignore these.  International stock indices tend to have higher fees.  If you get a broad-based index fund it will already include blue chips and tech stocks.  If you get a target-date fund, it will most likely include emerging markets and international markets in addition to bonds.

Diversification can also hide money from creditors like colleges or debt collectors.  Your primary residence has certain safety threshholds depending on where you live, but it can also be taken away if you use it to secure debt (as with a mortgage).  Your retirement savings is often protected.  Trusts and companies are other ways of protecting assets.

So… I recommend some thought exercises.

1.  Do you have an emergency fund that can cover reasonable emergencies (ex. water heater explosions, a delayed reimbursement, etc.) until your next paycheck?  That should be your first priority.

2.  Are you investing up to the match in your employment retirement account?  If you have low-fee options, put it in a target-date fund.  If you don’t, then compare the fees for the different index funds and pick a broad-based fund (if all things are equal, try to get one that matches the total market or the Russell 5000, but if the cheapest fund is the S&P 500 get that, and it’ll be ok).  For additional retirement savings it’s all about your employer fees and whether you qualify for an IRA and if you want to do a backdoor IRA.

3.  What are you doing about housing?  How much of your house is your net worth?  Do you want to buy a house in the future?  If you already own a house, how accessible is the money in case of an emergency (ex. having to move and the house not selling right away)?  For many people, the house is their main form of retirement saving besides Social Security, but in terms of diversification, this is not a great idea.  On average real estate goes up at the rate of the markets, but that’s the average– owning a single home doesn’t give you the average (it is the opposite of diversification).  If your housing market drops, you could lose a lot of savings (of course, it can go the other direction as well– we have friends in California who bought in 2008 and have gained a million dollars on paper since then).  So try not to invest so much in a house that having the market crash could devastate you.  Note though that whether or not you think it is ok to foreclose should also guide how much you’re willing to have in housing mortgage debt vs. equity (vs. renting).  In general, we do not recommend home-ownership unless you can put 20% down– yes lots of people manage ok putting less down, but lots of people were also put in bad situations having to short-sell or foreclose during the last housing crisis.  Basically, think about the worse case scenario and what would happen.

4.  When do you need the money that’s sitting in your bank account wanting to be invested?  If it’s less than 5 years, you can leave it there, or put it in cd ladders.  If it’s more than that, think about your time horizon–   are you investing for college?  Use a 529 (put it in one of their target-date funds).  Are you investing for retirement?  Use a target-date fund (or read some bogleheads forum about people in your situation).  Are you planning on buying a house in 8 years? Put it in a taxable mixture of stocks and bonds (what mix?  depends on how flexible your plans are given the vagaries of the market– to be honest, we just put it in the S&P 500 and cds as we got closer.)

Always do a mental run about what you expect on average to happen and what will happen in a reasonable worst case scenario (ex. 2008 stock market drop plus job loss, keeping in mind that the stock market increased before the drop, so it’s not like it’s 40% off what you put in, but 40% off what you put in plus your gains– the longer you’ve had it in the market, the more money you still have even after the drop).

Because a lot of diversification is about avoiding the low lows even if you miss out on the high highs.

And about acknowledging that long-run risk is different than short-run risk.  In the long-run, stocks will go up more than bonds or savings.  In the short-run, stocks are risky.

Satisficing will get you pretty close to optimizing risk vs. return.  A Vanguard target date fund is probably good enough, and it’s definitely better for long-term investing than just leaving money in a low interest savings account.

Here’s some next stage financial advice. Resources for asset allocation.

Grumpy Nation, how do you approach diversification?

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6 Responses to “Ask the grumpies: How do you approach diversification?”

  1. Debbie M Says:

    I like how you say that the point of diversification is to mitigate risk. When people talk about risk, they’re mostly talking about the risk of the economy changing–the ups and downs of particular businesses, industries, or the economy in general. But there are other risks to watch out for too:
    * Inflation – This is why you invest in stocks and real estate to begin with
    * Fees – This is why you go with index funds rather than managed funds or why you go with DRIPs and a buy-and-hold approach rather than constant trading.
    * Personal – I like how you talk about hiding money from creditors in a primary residence, retirement accounts, and trusts. Other vehicles for mitigating personal risk include things like insurance, safes, sprinkler systems, defensive driving classes, and legal documents.

    To answer your question, here’s where my money is invested, in order from biggest to smallest:
    * State pension and Social Security
    * House is paid off (supposedly >300K)
    * Roth IRA (index funds) (about 200K)
    * a few dividend growth stocks (generally US large-cap) (15K)
    * tiny HSA (index fund) (5K)
    * a few savings bonds (mostly I-bonds) (3K)

    My ideal asset allocation for my IRA and HSA includes 22% each of:
    * bonds
    * developed country stocks (I used to have 11% each from Europe and Asia, but my current strategy lets me have Canada, too).
    Then I also have 11% each of:
    * US large cap stocks
    * US small cap growth stocks
    * US small cap value stocks
    * REITs
    * emerging stocks

    Of course I also have savings accounts (one with Alliant Credit Union paying 2.1% interest). And I have a rewards credit card (with Alliant, paying 2% cash back) and a Target debit card (for a 5% savings on Target purchases).

    For insurance, I have health, dental, homeowners, flood, and auto. No vision (my glasses are cheap), no life (no dependents), and no disability (I’m retired now).

  2. Revanche @ A Gai Shan Life Says:

    I’m very antsy about having too much money in our primary residence and simultaneously about putting all our money into the stock market (because what if we had to leave the country?? screams disaster scenarios in my mind).

    I mitigated the first by paying down enough of the mortgage that it would have to lose at least 40% of the value for us to be underwater (though it would still hurt if we had to sell for only enough to cover the outstanding mortgage). I mitigated the second by taking on a rental property but it’s a lot more work than I really want to be doing.

    So we are invested in:
    – Stocks (401K, IRAs, brokerages with indexes and dividend stocks)
    – Some bond indexes
    – rental property.

    I don’t consider our primary residence an investment really. It’s our place to live and a liability until it’s paid off (and even then the property tax remains).

    We have the standard homeowner and earthquake insurance, life insurance for both of us and long term care insurance for PiC through his employer. I should figure out how to get long term care insurance for myself as well plus long term disability for both of us as well but honestly I can’t add another bill to our budget.


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