Once you’ve settled on your target mix of stocks, bonds, cash investments and alternative investments, and then decided how you’ll diversify within these categories, you have your portfolio’s framework. This will drive your portfolio’s risk level and its potential return. The next step: Decide which investments you’ll buy for each slot in your portfolio, such as the 15% you plan to invest in large-cap value stocks, the 5% you have earmarked for emerging stock markets or the 10% for short-term bonds.
For the vast majority of investors, the right choice will be funds, whether they’re actively managed mutual funds, index mutual funds or exchange-traded index funds. If you’re investing through your employer’s 401(k) or similar retirement plan, mutual funds may be your only choice.
What about buying individual stocks and bonds? Unless you have a multi-million-dollar portfolio, it’s hard to purchase enough individual investments to get broad diversification. One rule of thumb suggests you need at least 20 individual stocks to be diversified. While that might be enough to reduce the risk that you will be seriously hurt by a single rotten stock, you still run the risk that your stock portfolio’s performance will lag far behind the market averages. To eliminate that risk, you will probably need to buy funds.
Moreover, when investing in foreign securities, funds are the only practical choice for the typical investor. An additional reason to favor funds: You’ll likely find it less nerve-racking than owning individual securities, because the diversification offered by funds should make for a smoother ride.
Any exceptions? You might avoid fund expenses by purchasing individual Treasury bonds, where there’s scant risk of default and hence diversification isn’t that important. That’s discussed in the chapter on financial markets.
If you have the speculative urge, you might also set aside 3% to 5% of your portfolio for a “fun money” account and use that to purchase individual securities. One approach: Mentally divide your portfolio into three parts—growth money, safe money and fun money. The growth money would be in stock funds and other riskier investments, and you would expect a rough ride. The safe money would be in conservative investments, and you would keep enough there to give you a sense of security and cover upcoming portfolio withdrawals. Finally, the fun money account would hold any dollars you’re prepared to lose. Don’t like the idea of losing? Skip the fun money account.
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