Now that we’ve established the importance of minimizing systematic and unsystematic risk, let’s discuss the upside associated with risk: larger payouts over time. First, it bears repeating that you will typically make more money from stocks than bonds. There is “equity risk” in owning stocks, but over long periods of time (e.g., twenty years or more), you can expect a higher return.

Second, small companies are riskier than large companies, but the payoffs associated with the successful ones are much higher than the returns from large companies. Similarly, companies with less liquid capital (so-called “value investments”) tend to yield larger returns than financially strong companies.

When diversifying a portfolio, invest in assets with negatively correlated price movements so that when one goes down, the other has the potential to offset it by increasing. By choosing assets that are unrelated or negatively correlated, you can protect your overall portfolio from the risk of being harmed by unpredictable events.

Nobel Prize-winning economist Harry Markowitz, Ph.D., showed that it’s possible to have two assets that look volatile individually, but when combined in a single portfolio, reduce volatility and increase the potential rate of return.

In investment terms, if you have a Large U.S. Stock portfolio, all in the S&P 500, your portfolio will be vulnerable to risks affecting the U.S. economy. But it’s possible to reduce your level of risk without reducing your potential returns if you diversify further. By blending many individual investments into a portfolio, you create an overall portfolio that is less risky than its individual elements and can even yield greater returns. You could accomplish this by selling off some shares of U.S. funds and purchasing Small International Stocks. Large U.S. Stocks and Small International Stocks are not highly correlated so combined they reduce risk in your portfolio.

The simplest way to enjoy these benefits is by buying into low-cost, well-diversified mutual funds.

To better understand why Asset Allocation and Diversification are so important, we turn to mountains of research by Nobel prize-winning economists.

In 1990, Harry Markowitz, Ph.D., he was awarded the Nobel Prize in Economics for his research on the optimization of portfolios along what he calls the Efficient Frontier. He knew that people sought the best returns possible given their risk tolerance, and showed that diversification could be used to create a portfolio that minimized risk for each given level of return. He also demonstrated that the only way to improve returns was to increase risk, as measured by stock volatility.

To understand the importance of diversification, we must understand the types of risks associated with any investment. The most intuitive risk with a stock or market sector is that the underlying company will experience hardship or failures for reasons unique to it or to its industry. Maybe it is the target of a large government enforcement action. Or perhaps its CFO is caught embezzling money or misreporting earnings. Or perhaps a natural disaster wipes out an essential resource, like a particular crop or a critical piece of a supply chain (e.g., oil pipelines).

A famous example used to describe diversification is the street vendor comparison. Vendor 1, Amy, sells sunglasses and sandals, while Vendor 2, Brittany, sells sunglasses and umbrellas. Amy might sell both of her products to the same customers at the same time. Her sales are “positively correlated” because they are both in demand on sunny days. Brittany, by contrast, will rarely sell both items to the same customer on the same day. Her sales are “negatively correlated.”

While Amy may make more money than Brittany over the course of a sunny summer season, one rainy summer could put her out of business. Brittany, by contrast, will not make as much money as Amy on sunny days, but has minimized her chances of losing money on any given day.

A single bank is more likely to go bankrupt than its entire cohort of similarly sized banks. There is also more volatility in investing in a single stock as opposed to the whole market. If you spread your risk across hundreds of stocks, the companies that underperform will have little effect on your portfolio.

Fixed income investments are typically municipal bonds or treasuries) that pay a predictable premium on a regular schedule. They are considered “fixed” because the amount of the premium is known in advance.

A correlation is a connection or relationship between two or more things. Investments that are “positively correlated” will be affected by the same systematic risk, such as a slowdown in manufacturing in Japan. Investments that are “negatively correlated” will not be affected by the same conditions, and their prices won’t respond in the same way.

Systemic Risk generally refers to an event that can trigger a collapse in a certain industry or economy.

Systematic Risks refers to overall market risk. It is the risk inherent to the entire market or market segment. For example, if you hold only one stock, you run the risk that something will happen to the company you invested in and not to its counterpart. If McDonald’s has a food recall, Burger King does not suffer. You can reduce systematic risk by diversifying your portfolio.

Unsystematic Risk refers to a company- or industry-specific hazard that is inherent in each investment. Things like rainy weather are called “unsystematic” risks for a company that focuses on selling products for use in sunny weather. They are unsystematic because they don’t affect the market as a whole – just an industry, or a specific company. A recent example is energy stocks. In 2016, the price of oil plummeted to per-barrel prices not seen since 1999. As a result, energy stocks plummeted in value. Because these unsystematic risks are, by their very nature, unpredictable, it is risky to bet on just one company or one industry. That’s why diversification is far more prudent than betting on what you think the next hot stock or sector might be. In general, the fewer investment vehicles you have, the larger your unsystematic risk.

Uncompensated Risk is taking risk when there is no reward, or upside. Without diversifying, you subject yourself to volatility and unsystematic risk typically with no good reason for doing so. Without a crystal ball, there’s no legitimate reason to think that certain stocks are going to outperform the market as a whole. On average, you do not reap any extra reward for that extra volatility.

I’ve alluded to different investment options, such as mutual funds or index funds. There are three options, so let’s consider them here.

1. Buying Individual Stocks
You can open a brokerage account and buy your own stocks, but as we know, stocks carry a lot of risks. Relative to options that aggregate many stocks, you are holding a lot of extra non-systemic risk without an offsetting reason to expect additional returns. Because individual company problems are unpredictable, individual stocks are a poor way of implementing an investment strategy. Moreover, this is a labor-intensive option, and it will require that you stay on top of the news for each company in which you are invested, and judiciously avoid the Investor’s Dilemma.

2. Actively Managed Funds
Another approach is buying actively managed funds, but the research says that active management does not work. The simple fact is that the vast majority of active managers underperform their benchmark, even though active funds are more expensive than the more passive options.

3. Indexing
Indexing is a third way to implement your strategy. Indexes are pegged to a specifically defined set of stocks. They require little management, and therefore the fees are lower relative to other options. But indexes have their own problems. If you choose a Sector Fund, which is limited to a particular market sector, such as technology, or even the S&P 500, you run an unsystematic risk due to insufficient diversification. Remember, from 1966–1982, the return on Large U.S. Stocks after inflation was zero. One of the best ways to keep your costs extremely low is simply to cap-weight a portfolio to large companies, because it requires no effort whatsoever.

Size-Based Indices
If you choose a capitalization-based index, such as the S&P 500, you may be diversified in terms of market sectors, but you are missing out on potential gains from smaller or Value companies.

Sector Funds
Sector fund-investing refers to using an index pegged to the performance of companies in a particular market sector, such technology, or oil, or mining. This involves betting on market sectors and is one of the riskiest investment strategies due to the lack of diversification. If you own only a handful of stocks in a sector that is decimated, your investment could be wiped out (think of what happened to horse-drawn-carriage makers after the advent of the automobile).

As economists have shown, it is safer to diversify across sectors and sizes to ensure you have a healthy mix of investment classes with a low or negative correlation. That way, there will always be some investments that will do well and offset the impact of those that perform poorly.

Reconstitution
Another issue with indexing is reconstitution. The S&P 500 is an index of the 500 largest U.S. companies. What happens when some of these companies are removed from the index? Everybody who runs an index fund must sell those companies within a short period of time and buy the companies that have edged their way into the top 500. Hedge fund managers take advantage of this, buying up potential contenders to the top 500 before they make the cut, and selling the shares at a higher price when there is increased demand from index funds. The index is essentially forced to buy high by its own rules.

4. Institutional Mutual Funds
The fourth way of implementing your strategy is the one we use at Rosen Investment Management: pure asset class funds, or institutional funds. As we know, mutual funds represent the simplest way to diversify broadly. Many mutual hold over 10,000 different stocks. But not all mutual funds are created equal. A brokerage creates identical twin funds; one is marketed to the public (the “retail fund”) and the other is marketed to “institutional investors” (e.g., rich people or other funds). The goal is to keep the small investor out of institutional funds because small investors tend to panic and pull their money out more frequently (and usually at just the wrong time), which generates a high turnover and transaction costs.

At the opposite extreme of investments for young investors is money being saved for retirement. You’re not going to spend all of it 10 years, six–nine years, three–five years, or one–three years; it must last the rest of your life. For this investor, the goal is to generate a stable income for the rest of your life. Investing for that goal generally involves a portfolio with 50–70% stocks and the rest in fixed income. Many of my clients use a 60% stocks and 40% fixed income mix, which is a very traditional pension mix.

Let’s consider what happens with a 60:40 ratio in which you are taking a 5% distribution each year. Distributions come from the bond side of your portfolio, so at this point you are holding eight years of income (5% distribution from the 40% of your portfolio invested in bonds = eight years). One reason why we hold so much in bonds during retirement is that it allows us to buy time to weather downturns in the stock portion of your portfolio. You’ll want to be able to hold onto your stocks long enough to benefit from the subsequent recovery.

To accommodate the different investors’ levels of risk tolerance, we use four basic risk models: Conservative, Moderate, Growth, and Aggressive. Each refers to the time horizon of the investment.

Conservative Portfolio: 1-3 Year Time Horizon
With a time horizon of one–three years, it is typically advisable to put up to 25% of your money into stocks. The market may drop within a single year, but it is most likely that the investment will hold its value after two or three years. The remaining 75% of your funds should go into a mix of cash equivalents and short-term bonds.

Moderate Portfolio: 3-5 Year Time Horizon
If you plan to buy a house in four years, you can probably tolerate the risk, and reap some reward, from putting up to half of your investment into stocks and the remainder into bonds. This mix is intended to grow and preserve your money at a faster rate than short-term investments would. The additional time makes the risk easier to bear. Since bonds often move contrary to stocks, this arrangement helps control volatility within your portfolio. Adding more stocks also helps offset inflation risk.

Growth Portfolio: 6-9 Year Time Horizon
Six–nine years is a comfortable investment period. Looking back at history, the stock market typically recovers from slumps within this
time frame. For example, as the chart above illustrates, the S&P 500 recovered from the 2008-2009 “financial meltdown” in five-and-a-half years. Even with the Great Depression, the stock market plummeted, but eventually rose again. Plus, the divergent returns of stocks vs. bonds help control your portfolio’s volatility.

Aggressive Portfolio: 10 or More Year Time Horizon
Young investors have long time horizons, and as such should have aggressive portfolios. This portfolio is 100% stock-focused; that is, it is totally focused on growth. That may sound very risky, but it is a good hedge against inflation. (A 100%-stock portfolio can still be well diversified by varying the asset classes of the stocks.) In addition to minimizing inflation risk, the aggressive portfolio gives you the best chance of higher returns in exchange for higher market risk and volatility.

A 100%-stock portfolio should have a time horizon of at least 10 years to weather downturns in the market. In the worst case scenario, $100,000 invested in stocks would still be worth at least $100,000 ten years later. You would not be pleased with this outcome, nor would I, and while it is possible, it is probably the worst case scenario even though it’s the riskiest form of allocation. Remember the Investor’s Dilemma? In these circumstances, the key is to continue to hold.

We all want the greatest expected return for the lowest level of risk, but all of us have different tolerances for risk. The first steps are to consider when determining your investment objectives are:

1. When you expect to need the money and for what purpose, and
2. What type of risks are you most concerned about: inflation, interest rates, or market risk?

Answering these questions will help you identify your current level of risk tolerance. Based on your anticipated needs, your investment advisor can determine your time horizon and your commensurate risk tolerance.

A fund with a higher turnover ratio purchases and sells more stocks, bonds, and other financial instruments during a given period than a fund with a lower turnover ratio. More transactions mean more fees. Because using speculation, and gambling to manage funds is a poor investment philosophy, it’s wise to be wary of funds with a high turnover ratio.

Conversely, a fund with a low turnover rate incurs fewer transaction fees and is more likely to be operated by a fund manager who is tracking the market. Funds with a low turnover rates also offer significant tax savings considering that each time a fund manager sells a stock or bond, he must report the income earned as a taxable gain. These capital gains could be passed on to the fund’s shareholders through higher fees being paid from the fund’s income.

If your funds are going to be held in a taxable account, you may want to consider “tax-managed funds” that engage in strategic trading to minimize taxes.

According to Stephan Horan of the CFA (Certified Financial Analyst) Institute, the trading costs of stock funds amount to 2–3% of assets each year. These fees include advisory fees, operating expenses, sales costs, and marketing and other fees. These fees have to be paid even when you lose money in the fund. If the fees total 3%, the fund has to earn 3% just for you to break even. And that’s before accounting for inflation.