Building Your Stock Portfolio

Planning your stock portfolio allocation is the key factor for overall investment success. As was mentioned previously, the notion of constantly looking for new stocks to buy in order to get quick returns is a bit utopian and rather unrealistic. Building a stock portfolio takes strategy and commitment.

How do you build a stock portfolio?

Diversification is crucial. Putting all your money into one stock is a recipe for disaster. You need to mitigate as much risk as possible. How does diversification work? Imagine a scenario where you have $100 in cash ready for investing, and there are a bunch of stocks available for purchase. All stocks have a 95% chance of increasing your $100 to $116, and a 5% chance of losing everything. That means, at the end of the year, you will average ($116*0.95) + ($0*.05) = $110, or a 10% return on your money.

If you put all of your money into one stock, your expected return (or average) will be 10%, and your standard deviation or measure of risk (see 2 posts ago for explanation of standard deviation) will be equal to about 25.3%. For those interested, I used the formula:



Now, imagine that with your $100, you bought 20 different stocks, for $5 each. Your average return will still be 10% - in other words, at the end of the day, your $100 will still become $110 at the end of the year on average. However, if you do the standard deviation calculation, you will notice that your standard deviation in that case is only equal to about 5.5% (assuming a correlation of 0 between the 20 stocks – to be explained later).

How about that! Without sacrificing any returns, you managed to reduce your overall portfolio risk, simply by investing your money in 20 stocks instead of 1, even though all of the 20 stocks have exactly the same average return and standard deviation (individually) as each other!
Now you’re probably not as excited as I am about statistics. But the point is, diversification works.

However, there is one key caveat to diversification. Diversification only works if stocks move independently of one another. Back to our example of 20 stocks – if they all go up and down at the same time, in other words – they are perfectly correlated with each other, than the magic of diversification disappears. Why? Because if the correlation is perfect, you are essentially buying the same stock 20 times. This may be a bit hard for some of you to understand, but just trust me. In the example I used above, I assumed that all of the stocks move independently of one another. If one stock loses everything, that has no statistical bearing on the other 19 stocks. The other 19 stocks still have a 95% of growing by 16% and a 5% of losing everything. However, if when one stock falls, they all start falling, then the entire diversification strategy falls apart, and your overall standard deviation remains unchanged at 0.253.

One more mathematical concept to understand, and then you’re set to apply it to the real world. Correlation can be measured. A correlation of 1 is perfect correlation, or that when one stock goes up, the other stock will always go up as well, by the same proportion. A correlation of 0 means that there is zero correlation (like in the example used above). A correlation of -1 means negative correlation, or that when one stock goes up, the other stock always goes down by the same proportion. However, you are not just limited to 1, 0, or -1; you can have any value in between. A correlation of 0.5 means that when one stock goes up, the other stock also goes up, but by an average of only 50% as much.

Why am I telling you this? Because, let’s say, you want to invest your money in stocks, and you really like Apple stock (NASDAQ:AAPL). But then you remember Nechemya telling you that you shouldn’t put all your money in one stock. So you decide to put half your money in Apple and half in Microsoft (NASDAQ:MSFT). While that is certainly a better strategy than putting all your money into just Apple, because you have mitigated some of the risk by diversifying into 2 stocks rather than 1, it’s still a bit of a flawed idea. Why? Apple and Microsoft are both in the same industry (technology) and are therefore probably highly correlated with each other. If you put half of your money in Apple, and half of your money into Gillette, then you have achieved even greater diversification.

Companies within similar industries tend to have higher correlations with each other, as opposed to companies that are in different industries. This makes logical sense – take for example, Barrick gold and El Dorado gold. Both companies are involved in gold mining. If the price of gold decreases substantially, both Barrick and El Dorado will probably subsequently lose value. They often move together because they are affected by the same external environment. However, will Apple stock fall if the price of gold falls? Probably not. Therefore, by investing in Barrick and Apple (instead of Barrick and El Dorado), you are mitigating the risk of gold prices falling and negatively affecting your portfolio.

This same concept works for local vs. international companies. If you put all your money in Canadian stocks, then any factor that affects the Canadian economy is a risk factor for your portfolio. For example, if the Canadian government raises interest rates, a lot of the Canadian stocks you own may fall. So why not also buy American stocks. Throw in international stocks as well. In fact, the more you diversify the more risk you are mitigating. So, always diversify, preferably into stocks that are not strongly correlated with each other.

In fact, this same concept works for allocation classes. Why put all your money in stocks, when the stock markets are correlated with each other? That is why the best portfolios contain all allocation classes. For example, as I posted about 3 weeks ago, a properly diversified overall portfolio may resemble this:

65% stocks
15% bonds
5% precious metals/commodities
5% real estate
10% cash and cash equivalents

How many stocks do you need in order to maintain good diversification? An educated financial planner can probably effectively diversify with about 30 stocks. However, buying 30 stocks is extremely expensive, because there are transaction costs for each purchase you make. As well, it can be very time-consuming to research 30 stocks, and the mathematics of diversification can get pretty complicated.

There is an alternative. We have previously talked so much about mutual funds – this is exactly the reason why mutual funds are so popular. Mutual funds invest in hundreds, if not thousands of different stocks; all the while, you only need to make one payment to the fund. A mutual fund is a collection of money pooled together by many investors, and managed by a professional money manager. Therefore, with one purchase, you can own thousands of stocks at once, and achieve high levels of diversification.

The problem is that most mutual funds don’t do very well, and charge way too much money compared to the returns they give (see last week’s post). However, there are alternatives. Exchange traded funds (ETFs) are a wonderful alternative to mutual funds. I’d recommend researching on the internet about how an ETF works, or asking your financial planner. If you are the type of investor that wants a safe, easy way to invest in stocks without having to constantly monitor your portfolio, consider purchasing an ETF that invests in market indices all over the world.

Please remember to speak to a financial advisor before making large purchases in the stock market. Next week I will be discussing RRSPs and TFSAs.

Lastly, although younger investors are often fascinated by the stock market and the supposed riches they promise, do you remember what I said was the best way to save money and increase your wealth (about 5 weeks ago)?

Spend less than you earn.

Credit Crisis

This latest post is a quick aside to our regular personal finance topics.

I'm sure a lot of you followers have heard about the 2008 financial meltdown and the resulting recession. While you may have heard of terms like 'sub-prime mortgages', 'credit defaults', 'collateralized debt obligations', etc. - a lot of people are a bit confused about what actually happened that caused the financial market meltdown.

There is a short video I saw at http://crisisofcredit.com/ that explains exactly what happened in a simplified, entertaining, and remarkably accurate way. This video is also crucial in understanding the current fraud allegations against the most reputable banking firm in the world, Goldman Sachs. Check it out, and then maybe you can impress your family/friends about your knowledge of the financial meltdown, and the reason why it's so hard to find a job these days!

The Big Myth About Stocks

I’m sure you’ve all heard fantastic stories of investors who made untold millions in the stock market and retired like kings. You are also being constantly reminded by the mainstream media of all those Wall Street traders who make more money per week than 75% of the average Canadian worker’s annual pay check. You’ve always wanted a piece of the action, but never knew enough to enter the equity markets, or was simply too nervous to do so. Hopefully, by the end of the next few posts, you will have a better understanding of the equity markets and the best ways of entering them.

Firstly, there are a couple of notable distinctions that have to be made. There is a difference between what is called a ‘trader’ and what is called an ‘investor’. A trader buys and sells stocks on a daily basis, looking for quick returns on their money. An investor buys stocks for the longer run, and trusts the mathematics of financial principles to attain long-term goals. There is a huge difference between the two. Traders mostly rely on heavy technical analysis, which involves complex statistical methodology to try and pinpoint current trends in the trading prices of equities. This is not an easy thing to do – it is extremely fast-paced, stressful, and requires a lot of skill, time and energy. Suffice it to say that trading equities should not be the average family man’s strategy – leave it to the experts with millions of dollars at their disposal, and very low transaction costs. I am going to be talking about investing for the long-run. The premise of the investor is that the overall average of stock returns is 11%/year – and that the actual choosing of individual stocks (often) doesn’t really matter – what matters is the allocation of stocks. In other words, what matters is the type of stocks do you buy, as opposed to which specific ones.

My goal here is not to give you advice about which stocks will be going up next week or month. Why? Because your guess is as good as mine. In fact, your guess is as good as most of the professional money managers heading the giant mutual and hedge funds, and who are getting paid millions to do so. This brings us to one of the most eye-opening and fascinating studies in the history of finance. In 1973, Princeton economist Bernard Malkiel published a book called ‘A Random Walk Down Wall Street’. In it, he described an (albeit thought) experiment, where he had monkeys throw darts at listings of stock securities on the market. What he found was that monkeys’ stock portfolio managed to out-perform the majority of the mutual funds on the market (??!!). Malkiel concluded that by owning a portfolio of random stocks, or more simply, by tracking the market index (to be explained later) and holding on to them for the long-run, you are more likely than not going to outperform the vast selection of actively managed mutual funds on the market.

The debate rages on even today, about whether there is any point to having traders and actively managed portfolios, as opposed to passive long-term investors (actively managed portfolios refers to people who are actively and continually trying to pick winning stocks; passively managed portfolios are portfolios made up of a selection of stocks and held for a long time without interference, or by tracking the returns of a market index, such as the TSX). The funny thing is that the whole conundrum is a catch-22: The reason why the monkeys can outperform money managers is because the stock markets are efficient – there are no discounts or good buys on stocks. All stocks are priced correctly, and therefore, you can’t make quick returns by being a trader. Traders therefore get outperformed by the average market index (or the monkey), because of increased transaction costs resulting from more frequent trading. But the reason why stocks are priced correctly in the first place is because the traders are constantly trading them! If all the traders in the world stopped trading, markets wouldn’t be as efficient, and then there would be more room for individual managers to beat the monkeys, by finding stocks that are underpriced. I hope I’m not confusing you!

Anyway, the point is that it is extremely hard (if not impossible) to consistently beat the average returns by picking winning stocks (over the average stock return). It’s simply a statistical game - exactly comparable to throwing dice. If you roll a die, there’s always a chance that you will roll a 6. But if you do, does that mean you’re a better dice roller than the average? Of course not! It means you got lucky; subsequently, your first dice roll has nothing to do with your second one. The next time you roll the dice, you are equally as likely to roll a 1! This is completely analogous to most mutual funds. If a mutual fund outperforms the average return in one year, it has almost no bearing on the fund’s return for the following year. In other words, it was all luck.
Therefore, if you heard about someone who managed to outperform the markets for years on end – chances are they are lying, or got extremely lucky. The probability that they could repeat their performance isn’t any better than you doing so.

So after contemplating what I just said you are probably wondering why there is such a massive financial industry. Well – it’s all about what you believe. Some people believe in Malkiel’s theory, and some don’t. Studies on the subject are mostly mixed and inconclusive, but one thing that I’m certain about is this: The overwhelming majority of Wall Street financial firms make their money off charging clients for their trading, rather than the trading itself. This is perhaps the biggest myth of finance dispelled. Mutual fund managers are paid millions not because they earn high returns, but because they charge a lot of money to handle your funds. I can assure you that the vast majority of mutual fund managers would not be able to earn money on their own (in the stock markets) – they manage other people’s money and charge them for doing so. The number of people who can actually consistently become rich via equity trading is as rare as moon dust. You may have heard of some of them – Warren Buffett, Peter Lynch, Bill Miller, etc. The funny thing is that supporters of Malkiel would argue that these investors didn’t do it on their own – they had access to resources that the average investor would never have. Otherwise, they wouldn’t do any better than you or me.

Does this mean that all actively managed mutual funds are bad? Not necessarily. Studies have shown that about 1 in 5 actively managed funds can beat the market index (market average) consistently over the long run. Does this disprove the theory that’s it’s impossible to choose winning stocks? It’s anyone’s guess! Mutual funds can still be of much value, just you cannot blindly throw your money at them because they supposedly have professional management. Most professional money managers do worse than the average, not better.

As well, some traders have found success using technical and fundamental analysis. I would not advise the average investor to start trading equities unless you really have a solid financial background, and that you understand what you’re getting into.

Whether you believe in Malkier or not, the takeout lesson is that there are no get-rich quick schemes in the stock market. Successful investing takes patience, strategising, commitment to principles, dedication, and above all, realistic expectations. Interestingly enough – of the 20% of funds that do manage to beat the market index, most of them are the ones who practice exactly the principles I just mentioned (dedication, patience, etc.). As soon as they get greedy and chase higher returns – they inherently accept more risk in their portfolio, and they end up getting burned over the long run.

The smart investor worries more about the allocation of stocks, rather than the choosing of stocks. The smart investor focuses just as much of his attention on how his/her returns are going to be taxed, as the returns themselves. The smart investor always considers the riskiness of his/her investments.

And lastly, perhaps most importantly, the smart investor does not pay attention to past returns of individual stocks. You may open the newspaper today and see that Apple or RIM stocks went up 10% yesterday. Remember, that although you may be tempted to now buy Apple or RIM, the fact that the stock went up yesterday has zero significance with today’s performance. Yesterday’s returns have absolutely no statistical bearing on today’s or tomorrow’s returns. This has been proved over and over, so never chase previous returns!

You need to develop a long-term strategy, and you need to stick to that plan. Obviously, the strategy can be amended at particular points in time, but the dedication to strategy remains essential. Next post I will discuss the principles of how to create an investing strategy, and then show you the nitty-gritty of how to purchase equities (i.e., where to purchase stocks, how to research stocks, day to day portfolio monitoring, etc.).

Portfolio Allocation Continued

Let’s finish our discussion about portfolio allocation. The all important 3 general rules about personal investing were explained in last week’s post: 1) always diversify your (risky) holdings, 2) recognize the importance of saving early and the subsequent power of compounding interest, and 3) understand the risk/return trade-off inherent in finance.

So how should you construct your portfolio – in other words, where should you put your money?
Firstly, most financial advisors would tell you that it’s crucial for every family to have an emergency fund, equal to between 3 - 6 months worth of living needs. This fund should be very liquid, meaning that it is very easily cashable and therefore instantly retrievable. Liquidity also implies a low level of risk. You can simply keep this money in the bank in a savings account, or you can also consider a money market fund. Money market funds act like mutual funds, but instead of investing in a variety of risky stocks, money market funds invest in mostly safe government debt and treasury bills that have short terms – i.e. 90 days, or even less. These funds can often give you higher returns than a savings account in a bank, but are not any riskier. All of the major banks offer money market funds – just walk in and ask them about it. The key questions to ask are: how liquid is the fund (i.e. if I need my money, how quickly can I get it)? Next, is there a fee for pulling out? And finally, what is the MER (management expense ratio)? The MER is a crucial statistic for any mutual fund – it’s what the fund managers will charge for managing your money. Some funds have an MER as high as 3% (i.e. they take 3% of your money every year, regardless of whether you gained or lost money during the year). Make sure that the average returns on the fund over the past few years exceed that MER. Believe me, don’t put it past the banks to charge you more money than you will earn.

If you cannot find a suitable money market fund, just keep the emergency stash in a savings account. Especially nowadays, when government debt is paying the lowest rates in history, it may not be worth the while to shop around for a money market fund. You can look for financial institutions that offer higher returns on their savings account; just remember, liquidity is the main objective here. Make sure before you sign away your money that you can easily retrieve your money without incurring penalties.

Okay, so you’ve set up and safely put away an emergency fund. What to do with the rest?
In the last post, I introduced the topic of risk. To re-iterate, the question of how risky you should be with your money is directly related to the question of “when do you need your money?” The sooner you need your money, the less risky with it you should be. If you are saving for a down payment on a house (within the next few years), I would highly recommend against allocating a large portion of your savings to stocks, unless you fully understand how the stock market works and also appreciate the risks involved. However, if you are young and saving for retirement – there is more room for riskier investments. I’d advise you to speak to a financial advisor before getting involved with stocks, or at least do your research beforehand.

Another factor is your personality - some people are far more conservative, and would rather see their money safely earning modest interest and growth. Others are more risky and can stomach variation within the markets. It's not easy - imagine investing all your savings in stocks, and then seeing 5% of it vanish in the first few months. If you're the type of person that will pull out in the short run (in the aforementioned situation), stocks may not be right for you. However, if you trust the markets and are willing to wait it out for long-term gains, then you more suited for riskier strategies.

Don't think personality is a 'soft' factor in portfolio allocation strategies - many theories in finance are based on the 'risk appetite' of the investor.

If you are looking for safer investments, try GICs (guaranteed investment certificates). GICs are simply basic cash investments that the bank holds on to for a certain time period and pays interest on the investment. The drawback is that GICs are usually not cashable for the duration of the term. GICs are offered by all banks, and they vary with term length and interest rates offered. Do shop around for different rates offered by the different financial institutions.
To note, default risk on GICs are practically zero. However, there is still a considerable amount of interest rate risk (see last week’s post), especially in today’s economic environment, as interest rates are expected to jump over the next few years. Since interest rates are expected to jump, if you are shopping for GICs, perhaps get shorter term GICs (i.e. 1 year versus 5 year), so that next year you can re-invest in a higher returning GIC, instead of being locked in at a lower rate for 5 years.

There are plenty of opinions and ideas out there about how an average portfolio should look - every financial situation is different, so do your research first or speak to a financial advisor. Nonetheless, i'll outline a typical retirement savings portfolio for a 35 year old:
70% stocks
20% bonds
10% cash and cash equivalents (treasuries, GIC's, etc.)

Within each allocation class, diversification is key. For example, the stock segment will contain stocks of different industries, dividend vs. growth stocks, etc. (these concepts will be explained next week). However, even amongst the allocation classes, many advisors would even advise to diversify further - perhaps in real estate, commodities (such as gold or silver), etc. For example:
65% stocks
15% bonds
5% precious metals/commodities
5% real estate
10% cash and cash equivalents

If you are looking to build a long-term portfolio with risk – remember to diversify. Next week, I will talk about how to enter the stock market safely and efficiently. The bond market is also a great place to invest your money, especially for more conservative investors, but the corporate bond market is arguably the hardest to understand (amongst the major allocation classes). Again, I’d recommend you referring to someone who knows their way around the bond and equity markets before you get involved.

Portfolio Allocation

The question of “Where do I put my savings?” has inspired the $11 trillion dollar mutual fund industry, countless magazines and articles, and even an entire workforce of financial planners and advisors. It is the most difficult question to solve in personal finance, because there are no certainties in investing. In taxes, insurance, mortgages, etc. – there are (for the most part) final, calculable answers; in investing, there are no ‘true’ answers, only opinions and estimates. It is therefore crucial to understand the theories behind portfolio allocation, so that you can understand how and where to put your savings, in order to give it the best chance at growing successfully.

This post is a bit theoretical and mathematical, but it explains 3 essential concepts to investing that all savers must know. If you don’t have the time (or stomach) to read through this, skip down to the bottom, where I summarized the 3 essential lessons. Next week I will get a bit more hands on, and actually show you how to invest your money.

What is the goal behind investing? It is to provide a return on your assets (or money). If you have $1,000 in cash that you wish to save, you’d want to invest it so that it grows over time. Why would you want to invest it? Because, contrary to the popular misconception, stashing your savings under your mattress is not the safest place to store your money. This is because of the concept of inflation, which erodes your money’s worth over time.

The return on your money is described in percentage values – for example, perhaps you want a 7% return on your $1,000 in savings – that will get you (1000*0.07) = $70 after the first year. If you invest your $1,000 a 7% for 2 years, will that get you (70*2) = $140 in interest? Nope! – In the 2nd year, you receive a 7% return on $1,070, which is equal to approximately $75, rather than $70. Your savings are now worth $1,145 (instead of $1,140). This concept is called compounding interest, where you earn interest on interest – and as will be explained later, is an extremely powerful tool.

For a typical portfolio, there are many places to put your money in, and the major categories include stocks, bonds, and treasuries (government bonds). Stocks are defined as a piece of ownership (or equity) in a public company, while bonds and treasuries are debt instruments – the corporation needs to borrow money, and you lend them that money with the purchase of their bonds. Here is a breakdown of the average yearly returns for each major category, since 1920:
Stocks = 11%
Bonds = 7%
Treasuries = 4%
If historical averages mean anything, stocks clearly provide the highest return for your money, on average. So then, if getting high returns is the goal of investing, why would anyone in the world buy bonds or treasuries instead of stocks?

Everyone understands the concepts of returns – the higher the return, the better. However, there is a second concept to investing (and even to all of finance), which is known as risk. Risk is defined as how volatile, or variable a return is. To illustrate, look at the 2 following scenarios:

Scenario 1:
Year 1 = 8% return
Year 2 = 6% return
Year 3 = 7% return
Average arithmetic return = (8+6+7)/3 = 7%

Scenario 2:
Year 1 = 53% return
Year 2 = 0% return
Year 3 = -32% return
Average arithmetic return = (53+0+-32)/3 = 7%

Both scenarios offer the exact same average return. However, which scenario is better? They’re both mathematically equal, yet most people are risk averse, and therefore consider Scenario #1 a lot more favourable. We are going to assume that you are risk averse – otherwise, you might as well take your savings to the casinos and try your luck there with investing. The aforementioned 2 scenarios illustrate the most crucial and elementary concept in finance – the risk/return tradeoff. In general, investments that are riskier provide higher potential returns, and vice versa. Interestingly, it is the risk that affects the return, and not the other way around. For projects and investments that are extremely risky, investors will only spend their money on it if the returns are high enough to offset that risk.

How can we measure risk? There are many ways, but the basic way uses a statistical value, called the standard deviation. Calculating the standard deviation is fairly simple.

Back to our question about stocks, bonds, and treasuries. Why would someone buy a bond over a stock if stocks provide higher returns? Because bonds have a lower standard deviation than stocks, and are therefore less volatile or risky. Are bonds therefore better than stocks? That is the million dollar question that every financial advisor will give you different opinions about. The theoretical answer is based again on the risk/return tradeoff. In other words, is the higher return on stocks enough to offset the higher risk of stocks? There is no true answer, but I can tell you what current financial theory does have to say about this question.

When I say that stocks are riskier, what I mean is that although you hope for an 11% return tomorrow, it could be that next year is a down year, and you actually lose money on your investment. However, over time, the long-term average of the stock is still 11%, and therefore, if you held the stocks for, let’s say, 50 years, you are practically guaranteed to end up with more money at the end of the 50 years than a bondholder. I can prove this to you statistically, but it’s mostly beyond the scope of this blog.

Therefore, the question of how much risk to take in your portfolio is related to the question of “when do you need the money?”

If you are 25 years old, and you are saving towards your retirement in 40 years, then I would advise you to engage in riskier investments, i.e. stocks. However, if you are saving for a down payment for a house mortgage, in, let’s say, 2 years down the road, it is probably a very bad idea to put all your money in stocks. Similarly, if you are 55 years old, you should put less money in risky investments, and more money in safer investments. The popular line goes that you should subtract your age from 110, and whatever that number is, that’s the percentage amount of your portfolio that should be allocated to stocks (regarding retirement savings).

Remember I briefly mentioned the power of compounding interest near the beginning of this post. Again, compounding interest means that you receive interest on interest already received in previous years. This may seem like a small amount at the beginning, but over a long period, compounding interest can provide exceptional returns.

For example, assume 2 scenarios, one with compounding interest, and one where you don’t receive compounding interest. Assume you have $100,000 in savings, and earn a 12% annual return compounded monthly (in other words, 1% per month), and that the investment period is 30 years.

Scenario #1 – No compounding interest: Essentially, you earn 100,000*0.12 or $12,000 each year, and multiplied by 30 years, you get $360,000 in interest earned, plus your initial investment of $100,000 = $460,000. Not bad - your investment grew from $100,000 to $460,000 in 30 years.

Scenario #2 – Compounding interest: How much money do you think you will have after 30 years? Care to guess? The answer is: $3,594,964.13. Your $100,000 investment grew to well over $3.5 million.

Another way to illustrate the immense power of compounding interest: If you put away $250 to your savings every month starting at age 35 up until the age of 65 (assuming a 12% monthly compounded return, and compounding interest), you would have $873,741 at age 65. But if you started putting that money away at age 25, then you would have $2,941,193 at age 65. What a difference 10 years makes!

The power of compounding interest grows larger and larger as the investment period gets longer. The difference between 30 and 40 years is comparatively way larger than the difference between 5 and 15 years. So remember, the earlier you start saving, the better!! If you start saving only $250/month starting at age 25, you will most likely be in a terrific financial situation near retirement. But if you only started saving in your 40’s, you’re going to have to make much larger sacrifices to end up with the same total portfolio value.

One last point. In this post, I kind of led you to believe that your portfolio can only consist of stocks or bonds. Nothing can be further from the truth! You can mix your portfolio with both bonds and stocks, or stocks and treasuries, or practically any other combination of investment vehicles. And here’s the real clincher: the more you mix, the better! You’ve probably heard about the concept of ‘diversification’. Mathematically, diversification allows you to earn the same return as an undiversified portfolio, with less volatility (or risk). Again, I can prove this to you mathematically, but it’s a bit beyond the scope of this blog.

Diversity is an extremely powerful factor, just like compounding interest is. If I told you that you should invest 50% of your portfolio in stocks, that doesn’t mean you should spend half your savings on RoyalBank stock. It means you should spend half your savings on a diversified holding of stocks, perhaps 100 stocks together. My own personal portfolio actually consists of many thousands of different stocks from different companies (I am being perfectly honest with you). Why would I do that? Because it lowers the total risk of my portfolio, without sacrificing any returns. How did I pull that off without being a billionaire? Wait until next blog, and I’ll show you!

Summary: That post was a bit theoretical, mathematical, and long (I know, I’m sorry). In summary, here are the 3 essential lessons that you should know about investing:

Lesson 1: Stocks provide higher returns than bonds, which in turn provide higher returns than treasuries. However, stocks are more volatile (or riskier). Therefore, the question of how much stocks you should invest in relative to bonds is really a question of when you need your money. The closer you are to needing the money (for example: you’re close to retiring, or are saving for a house purchase in the coming years), the less risky you should be with your money.

Lesson 2: Diversify, diversify, and diversify. Never put all your eggs in one basket, whether that means putting all your money in one stock, or all your money in the stock market in general. In fact, the more you diversify (i.e. the more different kinds of investments you purchase), the less risk your portfolio has, and the better off you are in the long run.

Lesson 3: Recognize the power of compounding interest over the long-run. Beginning to save and invest money at an earlier age has the advantage of utilizing the remarkable power of compounding interest. The later you wait to save, the more money you will need to put away to achieve your dream retirement living.

Stay tuned next week for more portfolio allocation essentials!