“It’s all God’s will: you can die in your sleep, and God can spare you in battle.”
-Leo Tolstoy, War and Peace
In Book Three of War and Peace Napoleon is finally introduced as the French army’s invasion of Russia commences in earnest. Pierre, the real main character of the book, convinces himself that Napoleon is the devil and goes off to war to and watches the Battle of Borodino, where the Russian army fought the French to a stalemate. In the depths of depression, Natasha, the object of Pierre’s heart, finds her faith and perseveres in Moscow. In short, the fortunes of individuals and nations begin to rise and fall.
Your fortunes will rise and fall if you invest, no matter what. But you can take some steps to increase they changes they rise overall instead of fall. Last week I talked a lot about diversification: buying lots of different types of investments to minimize risk. There are two basic ways to do this: 1) buy different types of assets, and 2) buy different types of options within an asset. Today, I want to talk about ways to diversify within two major asset classes: stocks and bonds.
You can basically do two things with stocks. You can buy them one at a time. Or you can buy them a bunch at a time. What do I mean buy a bunch at a time?
What I’m talking about are equity funds. There are really a million different types of funds. But to me, there are two basic types. There are passively managed funds, which track in index (INDEX FUNDS) and actively managed funds. When you invest in either of these types of funds, even if it is just $1, you get a percentage ownership of each stock, based on what percentage of investment that stock makes up in fund.
Passively managed funds are still managed by people, but they have lower costs than most actively managed funds because the manager needs to just buy stocks to track an index. An index is just a large group of stocks based on industry (i.e. healthcare, airline, etc.), size (small-cap, mid-cap, large-cap), and type (growth and value). Some indexes are total stock indexes and are meant to track the entire market. One example would be an S&P 500 index fund. The the index manager fund will invest in S&P 500 stocks, with the goal of mimicking the S&P 500 market.
Actively managed funds are funds where a manager does a similar thing, but then tweaks things, buying and selling stock so that the fund doesn’t just mimic the market, but actually does better than it. The problem with actively managed funds, from what I’ve read, is that active manages rarely do better than the market in the long-term, and because of their higher fees and higher turnover, usually do worse. Check out The Four Pillars of Investing by William Bernstein for more!
There are basically two big things you want to keep in mind when looking into equity funds. (1) What their fees are. In general, higher fees are going to hurt you in the long term, even if they come with a shiny fund manager who keep buying and selling things to “optimize” performance. (2) Your diversification. You can buy a total stock market fund, which mimics the whole market, and gives you lots of exposure to big stocks, small stocks, risky stocks and blue-chip stocks. Or you can buy, for example, a health-care fund, which just gives you exposure to how the health care market is doing.
I know, you got so excited about my discussion of stocks and equity funds that you forgot I wanted to talk about bonds also.
Like stocks, there are two main ways to buy bonds. You can buy individual bonds (ideally, a number of them) or bond funds. There are two big things to consider when buying bonds. First, is how risky the source of the bond is. If it is a company about to go under, the bond will likely get you amazing interest rates, but runs the risk of disappearing before it is fully repaid, along with your investment. If it is the federal government, your money isn’t going anywhere, although you won’t likely make much in interest.
Second, the length of time the bond takes to repay. Generally, short term bonds pay less because they are less risky. Long-term bonds pay more because they are more risky. Why more risky? Because there is always the possibility that interest rates will rise while your money is locked into a bond for years. If interest rates are at 3% when you buy a bond, and then rise to 5%, but you still have your money locked in at 5%, you are losing out on that extra 2%. Risky! Plus, if you try to sell that 3% bond on the secondary market because you need the money right away (yep, you can do that), it will sell for less.
Bond funds are a way to diversify across a large number of bonds, similar in that way, to equity funds. However, unlike equity mutual funds, which rise and fall based on the stocks they hold, bond funds act a little differently than just a group of bonds. This is because bonds are constantly being replaced (as they mature–a.k.a. are paid back) or sold as the market changes –bond fund managers often do not hold bonds to maturity. If interest rates rise, those bonds your bond funds are selling are less valuable (who is going to want to buy a bond returning 3%, when there are bonds out there returning 5%!? So they have to sell for a discount.). Right now, as interest rates rise, many bond funds are losing money, even though new bonds that come out are returning higher interest. Keep this in mind when deciding whether the immediate diversification of a bond mutual fund is worth it rather than just investing in individual bonds on your own.
At the end of the day, remember the cool thing about diversification. If you have money in both a stock fund and a bond fund right now, you are likely earning money in the stock fund, and losing money in the bond fund. But if the market starts to slow down, or interest rates stop rising, that trend could reverse itself!