Invest Like a Professional Article by: Ric Edelman
If investors learned anything from the 2000-2002 recession, and the corresponding decline in the stock market, they should have learned that their investment portfolios need to be diversified. So how knowledgeable are you about diversification and asset allocation?
You probably know that there are several asset classes, such as cash, domestic and international stocks, corporate and government bonds, real estate, precious metals, oil and gas. The question is: What percentage of your portfolio should be invested in each asset class? Well, there are two different approaches.
We could do market timing and sector rotation. However, this is extremely dangerous, as people make the wrong choices at the wrong time, selling when the market hits bottom and buying at the top.
Or we can simply own everything, all of the time. This is the notion of diversification, which says we don’t have to pick the best horse in the race. If we just bet on every horse, we’ll do fine. Of course, that raises the next question. Do we literally take our money and put it equally into each investment class? Or is there a better way?
That answer is right at your fingertips in the institutional financial press, such as Institutional Investor magazine, Pensions and Investments magazine, and CFO magazine. These are magazines written for and read by professional money managers as opposed to magazines written by consumers for consumers. If you want to achieve professional- level results, you must take a look at how professionals do it. Pensions and Investments magazine conducts an annual survey of the 1,000 largest pension funds in America. Why is it worthwhile to pay attention to the big pension funds? After all, you’re not a big pension fund. You certainly cannot invest your money as they do theirs. Or can you? Most people have never examined how pension funds manage money, but you will find it an interesting approach to consider. Let me illustrate why. If you took $100 and walked into a supermarket, and I took $100 and walked into the same supermarket, what are the odds that we would both walk out with an identical basket of grocery items? Not likely is it? Now suppose we both enter with $1 million to spend. What are we going to walk out with? We’ll walk out with identical products because we had to buy everything they had in the store. We had no choice. Similarly, what does CalPERS pension fund, with $182 billion in assets, or General Motors, with $102 billion in assets, buy? They buy stocks. They buy nearly every stock. They don’t have any choice.
The key is not what stocks they buy. They all own the same stocks. The question is: How much of each investment do they own? Let’s take that question to the next level. How much do they have invested in stocks vs. bonds vs. real estate vs. cash vs. international securities? The answer to that asset allocation question is the key to successful investing. That is why it’s so important for us to discover how pension funds are investing their money.
How Do the Professionals Do It?
There are five major asset classes: U.S. stocks, international stocks, bonds, real estate, and cash. So let’s take a look at how the pension funds invest. When Pensions and Investments magazine looked at the large pension funds, they demonstrated that among the 1,000 largest pension funds, there is remarkable consistency about how they manage their money. But the way they manage their money is remarkably different from how consumers manage theirs.
Now, who do you expect to be better at managing money â€” the pension fund managers or individuals handling their 401(k)? Clearly the pension funds were better. Pension funds owned 50% U.S. stocks and 17% international stocks. Individual investors had 70% invested in U.S. stocks, but only 5% in international. So pension funds have 67% in stocks, but individuals have 75%. Consumers are more aggressive, more heavily invested in stocks than are professionals. Now look at the bonds: Institutions have 23% in bonds; individuals have 5%. How about real estate? Professionals have 5%; the average individual investors did not invest in real estate. Finally, let’s look at cash: Institutions place about 5% in cash, just enough to meet their liquidity needs. But the American consumer has 20% in cash.
Think about these numbers. Consumers have too much in cash, no real estate, few bonds and almost no international investments. If you want to achieve professional-level results, look at how professionals do it.
Diversify Your Stock Allocation
There is another important distinction between professional money managers and individual investors. Professional money managers will not place more than 1% of assets in any one stock. However, individual investors typically place huge amounts of money in individual stocks, especially their employer’s stock. When employees have the ability to buy stock in the company for which they work, that’s exactly what they do. Often, half of their total stock allocation is in their employer’s stock.
Remember, pension fund managers never invest more than 1% of assets in any company, yet workers routinely put 43% of their investment assets in their company’s stock. This is wildly speculative and can be extremely dangerous. Workers are placing far too big a bet on the company they work for. Remember Enron and WorldCom? Make sure you don’t repeat those employees’ mistakes.
Many consumers say they only want to invest in the United States. They know and trust U.S. companies. Average investors need to change their perspective to invest like professionals. If you invest only in the United States, you will not invest in 7 of the world’s 10 largest companies. You will not invest in 7 of the world’s 10 largest insurance companies; you will not invest in 7 of the world’s 10 largest utilities. You will miss 8 of the world’s 10 largest auto, appliance, and chemical companies. You will also ignore 9 out of 10 of the world’s largest technology companies as well as 9 of the 10 largest banks. So if you’re thinking of investing in stocks, focus globally.
These are the asset allocation strategies used by professionals. I am not suggesting that you blindly copy what institutional investors are doing. You need to decide for yourself how much of your money is going to be in stocks vs. bonds vs. real estate, vs. gold vs. government securities. My point is that you need to be aware of how professionals invest money, and you need to realize the mistakes consumers make.
Diversification Lowers Risk
You might ask, “Why should we put money in bonds? Everyone knows that bonds don’t make as much money as stocks. So why don’t we just invest in all the different sectors of stocks?”
First, in a declining market there are no safe places to hide (remember 2000- 2002?). Second, remember 9/11? Wall Street closed for days. If you had money in stocks, you could not sell shares for several days. If you needed money for any reason, you could not get your hands on it.
A study in the Financial Analyst Journal reviewed the financial markets for the 20 years between 1972 through 1992. In the 1970s the stock market was declining, the bond market was going up, and the real estate and gold markets were moving sideways. The ’70s were followed by the bull market of the 1980s, when stocks did fabulously and interest rates dropped significantly.
An investment in 100% stocks during this 20-year time actually underperformed an even distribution over the five asset classes. The reason: The stock portfolio was twice as volatile as the highly diversified portfolio. Consequently, we know that owning stocks is beneficial, but over the long term you can make just as much money with the diversified portfolio, while assuming significantly less risk!
Almost everyone looks at return; few look at the risk they are assuming. Proper investment strategies consider both. Make sure you do too … and you’ll join the ranks of professional- level investors.
Ric Edelman, CFS, CMFC, RFC, CRC, QFP, BCM, is the author of five books on personal finance, including national bestseller The Truth About Money. His firm, Edelman Financial Services Inc., manages more than $2.4 billion in client assets.
Learn more about Ric Edelman and his bestselling program No-Nonsense System for Building Wealth.