Safety and Diversification
When thinking about portfolio performance and the desire to seek safe, predictable returns what is really safe? Bank accounts including the so called "high yield" savings accounts pay virtually no interest (0.4% to 0.7% in November according to BankRate and Nerd Wallet) and the same is true for other safe and liquid investments like bank CD's, short term US Treasury ETF's and the like. Currently, it looks like we will have very low interest rates for at least the next few years, based on what the US Federal Reserve (and indeed other global central banks') policy has been. This makes holding cash or cash equivalent investments very difficult to do with such low returns, especially when other investments like stocks are generally performing better. It's truly very tempting to move into riskier assets.
For example, the S&P 500 has returned 8.6% so far this year, although the Dow Jones Industrial average is -0.75% year to date after a recent rally. Year to date return for the Nasdaq, however, is 32.6%. These disparate returns are mostly due to the wide difference between how technology stocks have performed this year in the COVID 19 pandemic vs other industries and indeed, has been a cause for concern by analysts who have been calling it a "tech bubble" not unlike what we have seen in the past like say around 2004. I'm not sure I totally agree with that, since today's big tech companies are actually quite profitable (unlike the companies in the "Dot.Com" era that were all losing money) and we are talking about earnings multiples today versus sales multiples and other weird nonfinancial metrics in 2004. Also, with 10-Year Treasury yields at very low levels at between 0.7% and 0.8% currently, bonds aren't a great alternative to cash. One could argue that bonds are possibly riskier than stocks if we begin to see inflation, which will cause the value of 10 year bonds at such low rates to plummet if interest rates were to rise significantly.
In fact, if you are looking for yield, you can earn more in an S&P 500 ETF (SPY, for example, boasting a current dividend yield of 1.62%) than you can in a short term (1-3 year) government treasury bond ETF (VGSH, for example, which currently yields 1.37%). Certainly, SPY provides more long-term upside, inflation protection and a yield that's likely to grow as companies typically raise their dividends over time. On the flip side of that argument, you can also suffer a stock market crash like we experienced back in March that could quickly obliterate the value of SPY and which would take a long time to recoup, while an ETF like VGSH would likely go up in value in that scenario, and would certainly preserve your principal. In the end, it's probably not a choice of either SPY or VGSH, but rather having good diversification so that part of your portfolio is in the highly liquid, risk-free end of the spectrum and part of your portfolio is in the higher risk/higher reward end of the spectrum.
As for whether you should pick individual stocks / bonds or just invest in ETF's, the ETF's certainly work if you don't have time or desire to do the research and actively manage your account. They also have a very low cost, which is a huge factor in influencing long term returns. Also, investing in ETF's ensures that you enjoy market-average performance, which isn't a bad thing since most individual investors (not to mention professionals) have a hard time beating the averages anyway. Perhaps its best to allocate a portion of your portfolio to passive index funds and a smaller portion to active investing (again, if you have the time and desire to do so).
Broad diversification is very important for long term returns and the dual objective of wealth preservation and growth. Further, I believe diversification is key to surviving the volatile markets we have experienced over the past several years and seem likely to continue for the foreseeable future. This is what I have called Building a Financial Fortress. Here's my current portfolio allocation:
Stocks - 32%
Cash and equivalents - 22%
Real Estate - 21%
Bonds - 19%
Alternatives - 6%
Within the stock portfolio, I actively manage about 30% and the rest is passively managed through ETF's. This works well for me, but might not be appropriate for all investors. Alternatives include small positions in gold/silver, Bitcoin, royalty assets and a whole life insurance policy.
The Financial Fortress approach would ensure that you are broadly diversified across asset classes and your stock trading portfolio should not be a large component of your overall financial picture, so even if you suffered heavy losses (which shouldn't happen if you are managing risk appropriately), the impact to your net worth should be minimal. The diversification in your stock trading portfolio need not include other asset classes like bonds or real estate, unless you don't have exposure to those areas in other parts of your Financial Fortress. I'm not recommending any particular stock or strategy.
I hope you find this post useful as you chart your personal financial course and Build a Financial Fortress in 2020. To see all my books on investing and leadership, click here.
Stay safe, healthy and positive.