Personal Finance 101 with H. Swint Friday

Diversify assets and establish safety net

One question I routinely ask students on the final exam in my MBA Security Analysis and Portfolio Management class is to identify the key portfolio investment recommendations they have gleaned from the 40-plus research papers we cover throughout the course. I always gain new insight from each class' answers and have tried to narrow them down to some basic recommendations for the average investor. Following are a few of these guidelines that should help most investors.

First, diversify, diversify, diversify. Along those lines, investors need to take a holistic approach to their portfolio asset allocation strategy considering their job, home and other assets they own that they may not feel are true investment assets. Many investors typically have asymmetric portfolio allocations. That is, they tend to over-invest in one asset or another. One area in particular is our over-investment in our home. Similarly, people tend to over-invest in their company's stock or their business, putting all of their eggs in one basket. Sometimes this pays handsomely but many times this strategy leads to tragedy and the sad stories that we hear on TV or read about in the newspaper.

Every portfolio needs a mixture of equities (stocks) and fixed income (bonds) securities depending on the particular needs of the investor. For small investors, the best avenue to get into these investments is via mutual funds. In the absence of more thorough analysis of a given investor's needs, a simple principle is that the percentage of the portfolio in fixed-income investments is approximately the age of the investor. So, the average 40-year-old investor should have around 40 percent of his or her portfolio in fixed-income investments.

As investors approach retirement, they need to build a substantial safety net of cash and fixed-income securities that to some degree immunize their portfolio to the inevitable market fluctuations. Similar to Joseph's interpretation of Pharaoh's dream regarding the seven skinny cows eating the seven fat cows as seven good years being consumed by seven bad years, investors need to have at least seven years of living expenses in investments that are virtually risk-free.

Also, every portfolio needs to have both international and industry diversification. American investors have a substantial portion of their wealth already invested in the U.S. economy before making their first investment in a stock or bond. The bulk of their money is tied up in the real estate market via their house while their human capital is tied up in a domestic job. The best way to diversify away this substantial investment in the U.S. economy is to invest overseas. The best way to do this for the average investor is through international mutual funds or exchange-traded funds. Similarly, investors need to diversify across industries both in the United States and around the globe. They especially need to focus on investing in those industries that are not related to the industry where they are employed. That way, if their particular industry takes a fall, their investment portfolio may fare better than their job prospects.

Investors' risk tolerance, not their return requirements, should dictate their portfolio allocation. Many investors make the mistake of letting their desire for higher returns determine their portfolio allocation versus the level of risk they can truly tolerate in their portfolio. This chasing of returns leads many investors into highly risky and speculative stock investments such as high-tech stocks. One simple rule of risk and return that always holds in the market over time is the higher the return, the higher the risk. That is, the higher an investment goes, the further it can fall when things turn. Rather than gambling on these risky investments and risking having little or nothing for retirement, I recommend allocating more money to savings each month to accumulate wealth faster in a portfolio whose allocation is more conservative and, thus, more predictable.


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