We’re going to pick funds for your big goals, namely retirement and any goal requiring a diversified collection of investments. If your goal is longer than 10 years away and requires anything over $10,000, we’ll want to use a diversified approach. Goals with less time than that or with smaller amounts of money we’ll use only one or two funds. More on that later.
Let’s start instead with this Bankrate Asset-Allocation model.
We’re going to use four different types of stocks:
- Large cap
- Mid cap
- Small cap
We can get more technical than that, but let’s start with these four.
Some people have problems with the word “cap.” It’s easier than you may think. Cap is short for “capitalization,” or the amount of money the company is worth. For our purposes, just think “company” instead of “cap” and you’ll have what we need: large company, mid-sized company…etc.
Two days ago we figured out what percentage of stocks and bonds we need for each goal. Look at your current funds. Do you have those percentages? If not, mark overages to sell and move toward the other asset class. In other words, if your goal calls for $10k in bonds and you have $20k, you’ll make a note to sell $10k and move it to stocks.
But where do me move it?
That’s where portfolio construction comes in. I look at diversifying stocks as if we’re building a ship.
- Large cap stocks are your hull. They’re going to be the most durable.
- International stocks are the sail. Sometimes there’ll be air in your sail and other times not.
- Mid and small companies are the spinnaker sail. That’s the sail that makes you go really fast when there’s wind. When there’s no wind it won’t help at all.
If you’re really conservative, you can put all of your investments in the hull (large company stocks). We mentioned in the class that you can actually add more aggressive investments and still lower your risk.
So, instead of 100% large company stock, if we went:
- 70% large company and
- 30% international,
we’d actually have a higher return over time and less risk.
Make Your Portfolio
- 50% large company,
- 30% international and
- 20% small company
Notice that I started with 100% large company and in my examples peeled off smaller amounts into the other categories. I like more in stocks that are the backbone of the economy and less in more aggressive positions. I continually tweak away from the “hull” to make the boat move faster…which also makes it more dangerous.
Getting Even More Technical
Remember the Morningstar Style Box? Large, mid and small each have options:
- Growth, value, and blend. What do these mean? If you’re value oriented, you’re asking yourself, “Is this company on sale?” If you’re growth oriented, you’re asking, “Is this company going to take over the world?” A blend, obviously, is a mix of both.
So….to apply this, we can get more crazy. Want a boat that has less fluctuation? Move toward value-oriented funds. Looking for the next great thing? Go with growth-oriented investments.
Maybe you’re in the middle:
- 40% Large Cap Growth
- 30% International Blend
- 20% Small Cap Value
See how that portfolio takes a little less risk because I went with “safer” categories for international and small cap but moved my large cap risk up?
We can also do that with international stocks. The safest place internationally is just a straightforward international growth/blend or value fund. However, if you want, you can buy international mid cap, small cap, or what’s called “emerging markets.” This will give you exposure to countries like India, Brazil and Russia. They’ll bounce around a ton….so to be safe, you probably want that as only a subset of your international investment.
I’ll take the allocation above and tweak it because I want some emerging markets:
- 40% Large Cap Growth
- 20% International Blend
- 10% Emerging Markets
- 20% Small Cap Value
See how I started with the “hull” of the international investment (the safer part) and peeled off a little less to take some risk? That’s a safe path toward successfully “navigating your ship.”
Okay…now it’s time for you to do this yourself!
Two days ago we found out what percentages you need in stocks or bonds, now allocate your stock percentages among large/mid/small/international. You can safely omit midsize companies if you want to keep it simple.
- Create your allocation for each type of investment.
- Look at your funds that you’re keeping on your Morningstar sheet.
- Allocate them.
Now you’ll have holes in your portfolio…..AND we still need to look at bonds.