You may think if you’re going to invest in the stock market, you have to spend many hours dwelling over financial reports while researching companies. This is a common myth, which leads to investing avoidance because very few people want to spend their weekends doing stock research! The reality is that now most stock investing is done by simply buying index funds…
The Ability of Index Funds
You may have already read here that index funds allow investors and financial advisors to buy a small amount of stocks in hundreds, or even thousands, of different companies with one index fund purchase. Instead of buying one index fund, however, usually several different types of index funds are purchased to allocate risk among different kinds of investments. That’s what I’ll be writing about here. This is a simple and intuitive process, but that reality is often lost in financial lingo.
Given the ease, availability and low cost of index funds, investing has become less about researching and picking stocks and bonds, and more about putting the ideal percentage of money into different types of stock, bond and other types of index funds. This is called Asset Allocation, and long term investing using Asset Allocation has become the norm. The goal is to find a happy balance between risk and reward.
There are “standard” asset allocations created in the financial services industry based on an investor’s age, dependents, income and risk tolerance. Investing, then, is more often than not, using this standard allocation to invest money into index funds.
A simple asset allocation example, or “model”, is putting:
40% of your investment money in US stock index funds
10% in international stock index funds
20% in long term bond index funds
10% in global bond index funds
20% in “cash” or cash equivalents
Most investment accounts are “rebalanced” every year back to the originally planned percentages into each category, such as 40% in stocks or 20% in long term bonds, in this example. Since, during the year, the percentages in each category increase or decrease based on the price movement in that category, the rebalance is necessary to keep the amounts congruent with the originally planned allocation.
As you can guess, there are variations on this standard model that may include many types of stocks and bonds with varying levels of risk. Your investment portfolio could, for example, include junk bonds, small company stocks, or single country stocks, such as India, all through investing in those index funds! This is where investor or advisor skill comes into the equation.
Theoretically, some of the price movement of some of the investments will move opposite each other. This is called negative correlation in investing lingo. During the 2008 stock market correction, almost all types of investments decreased in value, so negative correlation is less than perfect, but nevertheless, it’s a valuable principle to consider when investing.
The Best Strategy
Is it better to just invest in that standard asset allocation model, or invest in bargains, then sell them when they rebound? There are reasonable arguments that just using the standard asset allocation is the best strategy (and certainly the easiest!) vs. doing some tweaking to the standard asset allocation based on analysis and cycles. As an investor, you’ll want to choose which method you want to use, either individually, or in working with a financial advisor.
Again, the norm is long term investing with the standard asset allocation model, but some financial advisors are more proactive in their allocations based on market and economic cycles. There are very few long term asset allocation models that have proven to provide exceptional long term performance, but they do exist.
If proactive investing interests you, or you have skills in a particular area, you may choose to allocate a portion of your investment money to a certain endeavor, such as bargain hunting among stocks, or real estate, and allocate the bulk of your investment funds to the standard asset allocation. This is a logical and safe way to test your investing skills.
The overall long term performance of any type of investment gravitates toward the long term results from the indexes, such as 6% or 10% for the stock market. The reality is that your investment performance depends on when you enter and exit the market, since most stocks move with the overall market. This means that the index performance is a good tool to use to estimate long term performance in your investment accounts.
When investing in the stock market, you’ll always want to know the basics first so you can lead your wealth. I’ve outlined those for you jargon free here in this free ebook. It’s my gift to help women become smarter investors.