Rules of thumb can be handy assessments to quickly size up complex situations. However, circumstances change, and some rules of thumb fail. To make better decisions, here are a few rules that require more explanation.
1) “I want lots of diversification.” We often review portfolios that have five or 10 different mutual funds. Those funds hold 200 to 500 different securities. In owning 1,000 to 5,000 different companies, a logical investor should assess whether they are getting diversification or “di-worsification.” Owning lots of investments is not good. You reduce the impact of any one company stumbling; however, you also dilute performance.
Statistically, a portfolio becomes diversified when holding 20 to 30 individual securities. There are simply not that many great companies in the public markets. As such, do you want 20 extremely good companies – or 1,000 mediocre ones? It is far better to concentrate on your best ideas.
However, even concentration can be misleading. If your holdings are all in the energy sector or real estate or gold, you aren’t diversified. As such, you still need adequate consideration to diversifying over a variety of different industries.
2) “Stocks are risky.” We hear academics and market professionals use the word “risk” as a one-size-fits-all description. Usually, when people say stocks are risky, they mean volatile. However, volatility itself takes on many variations.
Investing in stocks over any 52-week period can produce significant volatility. During the average year, the stock market will fall by 14 percentage points. That is a very bumpy ride.
However, by extending time frames to 10 and 20 years, stock market performance smooths out and delivers much more consistent performance.
More importantly, stocks have delivered the best opportunities for outpacing taxes and inflation over multiple decades. If stocks offer the best opportunity to mitigate purchasing power risk, then it is logical to view stocks as low-risk – if you have the appropriate time frame and stomach for volatility.
3) “The stock market ‘averages’ 9% per year.” Be mindful of the 6-foot-tall man who drowned crossing the river that averaged 3 feet deep. It is mathematically accurate that stocks average about 9% per year over long time frames. However, since World War II, the market has gained as much as 56% in one year and lost as much as 38% in a single year. To get to the average, you must incur a lot of volatility.
4) “Bonds are safe.” The 10-Year U.S. Treasury currently pays 1.5%. After receiving your interest, you pay taxes. After taxes and inflation, fixed income assets do not maintain their purchasing power. As such, it is quite conceivable that if you are a long-term investor, fixed income assets are highly risky.
Risk is dependent on what type of risk you are evaluating and the time frame over which you are investing.
5) “Financial markets are efficient.” Technology has increased the pace at which information is shared through the world. However, markets are made up of humans, or at least software programmed by humans. If the evening news is any indication, humans are anything but logical. As such, there may be quick dissemination of information, but it does not mean it is processed logically or efficiently.
6) “Stock-to-bond allocations should be 100 minus your age.” This old adage was popular when fixed income assets typically paid 6% interest. There are two problems with this advice. First, people are living longer and therefore are exposed to more purchasing power risk. Secondly, the 10-Year US Treasury now pays 1.5%. As such, the fixed income component of this equation pays 75% less than it has historically.
7) “A safe distribution rate is 5%.” This was conventional advice used for decades by investors managing retirement money. However, most of the time after World War II, the 10-Year U.S. Treasury paid about 6% interest. With the Treasury bond at 1.5%, a 5% distribution rate is too aggressive. A much safer distribution rate is 3%.
In reconsidering these old adages, recognize that stocks and bonds can be both risky and safe. Mostly, it depends on time frames and adequate diversification. People are living longer, but traditional cash flow assets, such as bonds, pay much less than they traditionally have. As such, investors may need to increase volatile assets while decreasing distribution rates to make their assets last. Lastly, recognize that “rules of thumb” are generalities that change with time and may or may not apply to you.