Most are aware of the volatility in the stock and bond markets these days. It is a roller coaster of ups and downs. I often compare stocks to a good old fashion adult wooden roller coaster. The track goes up and down on the coaster, just like stock values go up and down. On a wooden coaster, there is a little shaking and bumping along the way too. It is not the smooth ride of a steel roller coaster. The bond market is like a little kid’s roller coaster. There are also ups and downs, much smaller than the adult coasters. Generally, the stock and bond markets work in opposite directions. Purchasing stocks means you are buying ownership in a company; you are a shareholder. It might be a .000001% (or even less!) of ownership when you purchase 100 shares or 1000 shares. As an owner or shareholder, you often have voting rights. When the company is doing well and making a profit, it can give the excess cash to shareholders in the form of dividends or it may choose to keep that cash for needs within the company.
Additionally, the share price may go up and provide you with potential profit. It is an unrealized profit until you sell the shares of stock. An unrealized profit is a paper gain. There is no guarantee that you will receive that amount unless you sell the shares at the price. By selling the shares, you realize the profit. At that time, you lock in the gain on the share price.
For example, you purchase one share of stock at $750 on March 15th. On April 10th, it was listed for a price of $830. The unrealized profit is $80. This profit means nothing to you since it is unrealized and you are not selling on that date. On April 27th, you see the share is listed for a price of $790 and you choose to sell. You have a realized profit of $40. If this stock is in a non-retirement account, you likely will be reporting it on your tax return and paying taxes on the $40.
The $80 profit means nothing to you because you took no action on that day. That is the daily fluctuation in the market. One day your stock may be showing a profit of $65. The next day it may be showing a profit of $73. The next day maybe it dropped in value and the profit is down to $59. The interim profits, the unrealized losses mean nothing until you sell and have a realized profit.
Think about if all you own is that one share of one stock. On March 15th, you bought it for $750. On June 19th, the company declared bankruptcy and the stock price plummeted to $225. You have an unrealized loss of $525. The loss may be financially disastrous for you because you only own this one share.
You took a more significant risk because you owned only this one share. I am sure many of you can think of a few companies where their shares took this type of nosedive. What if instead, you decided to own stock in 15 different companies? Does this reduce your risk? Is there less risk if you own 15 different consumable product companies or 15 different automobile companies? What is the likelihood that all 15 companies would have that dramatic drop in stock price at the same time?
There is less risk in owning 15 stocks than one. If you further buy those 15 stocks in different types of companies, the risk becomes even less. Consider if you purchase shares in a technology company, a hotel company, a snack food company, a pharmaceutical company, a restaurant, an office supply chain, an entertainment company, and ended up with 15 stocks in 15 industries. Does that not reduce your risk even more?
This is asset allocation. When you purchase different kinds of stocks from the larger companies to the small or from domestic (US) to international stocks, the intent is to reduce your risk. We certainly can have a general market decline like what we have seen in the past few months where almost everything has declined in value. Having investments in different kinds of stocks can reduce the chance of the overall risk that you will lose everything. You are not dependent on one company’s success. There is a chance that one may go bankrupt. There is a chance that one will outperform and makeup for the loss of the bankrupted stock.
Asset allocation attempts to reduce the risk of the stock portfolio. Diversification takes this a step further. With diversification, you are further attempting to minimize the risk by adding non-stock investments to your portfolio. Your non-stock investment maybe bonds. Bonds are lending money to an entity. The government may need funds for a major project and cannot use current tax dollars. A company may need funds to launch a new product for research and development or other expenses unrelated to daily expenses. Rather than going to the bank to borrow money, the choice is to borrow the funds from the public in the form of issuing bonds.
As a bond-owner, you are a lender. As a shareholder, you are an owner. Lenders are creditors. If the company runs into difficulty later, the creditor holds a higher place in terms of getting paid out of any remaining funds. If the company runs into trouble, the shareholders are last in line to receive any assets. As a lender, you will get the interest rate that is agreed upon between the two parties. As a shareholder, you participate in the profit of the business. What you can receive as a shareholder is more variable because it depends on how well the company does.
Like stocks, there are different kinds of bonds. Bonds can be issued by the government – federal, state, or local governments. These government bonds may have the added benefit of the earnings being tax-free. A company can issue bonds. Bonds are rated. Triple-A bonds are considered safe. Junk bonds carry a higher risk of defaulting and not paying the terms of the bond contract.
Different types of stocks provide asset allocation. Different types of bonds also offer allocation. Put stocks and bonds together for diversification. You can add other investment products for even more diversification. You can add alternative investments like precious metals, real estate, limited partnerships, tax liens, notes, and others to provide more diversification.
Different types of investments can have ups and downs in different economic situations. Think about four or five roller coasters, all being interwoven and going at the same time. The intent is for the volatility of your overall investments to decrease and to reduce risk with appropriate asset allocation and with good diversification.
You may think that it would take significant dollars to achieve asset allocation and diversification. Mutual funds have made it easier to achieve. One mutual fund can have stocks, bonds, and alternative investments, achieving both asset allocation and diversifications. You may choose one mutual fund containing stocks, one mutual fund containing bonds, and one mutual fund for alternatives. It is fairly easy to achieve a goal of reduced risk through asset allocation and diversification for less than $1,000.
Do not be afraid to start if you only have a few dollars. It is possible to start and still achieve asset allocation and diversification.