Do you like to cook? Have a favorite recipe? Fall is here and one of my favorite things to make in the fall is chili. If you think about chili, there are three main ingredients—sauce, meat/beans (protein), and seasonings. You may make your chili from scratch or buy it from the deli or in a can, but the three main ingredients will always be included.
I like to make chili from scratch. My sauce is a combination of tomato sauce, diced tomatoes, liquid from canned beans, and sometimes a touch of ketchup (please don’t tell). I like kidney beans in my chili because that is how my mom made it. I also like lots of meat, but vegetarian chili is equally tasty. Then for the seasonings, I add chili powder (of course!), salt and pepper, onion, and green pepper; and top it with more onion and shredded cheese when served.
Although each of the three main ingredients is distinctive. It is the combination of the flavors of the ingredients that makes chili taste so great! The whole is better than the individual parts. Isn’t that true for any recipe?
The equivalent to chili in the investment world is asset allocation. What are the three main ingredients for asset allocation? They are stocks, bonds, and cash, which are also called asset classes. Each asset class has its own unique flavor which complements the others. The combination of the three will make a “tasty” portfolio.
What is stock? Stock represents ownership of, or equity in, a company, and the amount of your ownership is reflected by the number of shares. When you own a share of IBM stock, you are a part-owner of IBM. Owners or shareholders may get payments from the profits of the company. Those payments are called stock dividends. If a company comes on bad times, it may cut its stock dividend or do away with it entirely.
What does stock bring to the table? Potential for growth! When people talk about investing, buying stock is typically what they have in mind. Since the Standard & Poor’s 500 Index (the S&P 500 tracks 500 large U.S. companies) was created in 1926, the average annual return through 2020 has been 10.7% before adjusting for inflation, or about 7% after adjusting for inflation.[i] But it is not a steady ride. It is more like a roller coaster with dramatic ups and downs. “The 2020 financial roller coaster is a case in point. It took only about four weeks for the market to lose 32% of its value, plunging from the S&P record high of 3,358 points on Feb. 12 to 2,447 at the close on March 18, with wild swings along the way. The good news is that the S&P had recovered nearly all its losses as of mid-August.”[ii]
If you can ride out the downswings without panicking and selling, investing in stock may be right for you. It is not without risk, however, and there is no guarantee that your return will be positive. Money invested in the stock market is only for long-term goals, those at least five to seven years in the future. (More about risk in my blog: The Key to Investing – Know Yourself.)
What are bonds? Bonds represent the debt of a company, an IOU, or a loan. When you own a bond, you are a lender to that company. Let’s say that Intel wants to build a new factory in the U.S. One of their choices for financing is to go directly to the public to borrow the money. They do that by issuing bonds. During the time Intel has the use of your money, they will pay you interest. Plus, at a designated time in the future, Intel will return the money borrowed from you.
How do bonds add value to your portfolio? Although the price of bonds fluctuates, the degree of fluctuation or volatility is usually less than stock, and therefore bonds are considered a more conservative part of your asset allocation. There is also more certainty with bonds than with stocks. Unless the issuer experiences financial problems, you can expect to receive regular interest payments and the return of your principal at maturity. Should the company have problems, bond holders receive payment before stockholders. Bonds are a liability of the company while stock is equity. Debts are paid before distributions, if any, are made to owners.
When there is more certainty—less risk—then a lower return can be expected. Risk and return are related. From 1926 through 2009, bonds produced an average annual return of 5.8%.[iii] “As of June 11, 2020, the U.S. bond market, measured by the Bloomberg Barclays U.S. Aggregate Bond Index, had a 10 year total return of 3.92%.”[iv] However, over the twenty years since 2000, although not uniformly, certain bonds outperformed stock.[v] Bond performance greatly depends on the general level and stability of interest rates, and current interest rates are at historic lows.
The cash piece of investment chili is usually a money market account or a bank sweep account. It is a place to put funds before investments have been selected and in-between sales and subsequent purchases. Any interest or dividends you receive from your investments, unless automatically reinvested, will also be put in the cash portion of the account. Although you may receive some interest on your money market balance, its return will not add substantially to the growth of your portfolio, so most people like to keep the balance to a minimum. Remember, investing is for the long term. To maximize the potential for growth, funds must remain in place for as long as possible, ideally until your financial goals are reached. (See my blog: Set Your Investment GPS.)
The Recipe for Investment Chili
The trick, any cook will tell you, is to find the right mix of ingredients. When I make chili, I know the approximate amount of each ingredient because I have made it so many times. However, along the way I sample now and then to make sure I am getting the flavor I want.
You will do the same with your portfolio. (See my blog: The Key to Investing – Know Yourself.) You may start out with a particular mix of stocks and bonds and cash, and then find out you do not like its “flavor”. That is perfectly normal. As a person goes through life, goals, and circumstances change so it is appropriate for your investment portfolio to change its mix of stocks and bonds, too.
If you are a beginning investor, or if you have started investing but want to know if you are on the right track, look for my book: How to Dress a Naked Portfolio: A Tailored Introduction to Investing for Women. The book is full of understandable financial information to get you started, and it is packed with helpful resources. Asset Allocation is a major topic. Learn more at bevbowers.com.
Beverly J Bowers, CFP®