(music) Previously we saw how owning many stocks eliminated
"specific company risk", which is risk that can be diversified away. Now we are going
to see that it is not enough to simply own hundreds of companies. You'll learn the great
advantage of owning poorly correlated assets. This part is truly cool! Magical.
To help me show you, let's imagine two companies: Bathing Suits Inc. and National Umbrella Company.
A rainy year means sales at the Bathing Suit company fall but the umbrella company does
well. In a sunny year, the bathing suit company does well and the sales of umbrellas fall.
The price of these company stocks move in opposite directions so they are negatively
correlated. The Bathing Suit company is more volatile because the total annual return has
an average value of 7% but a variable component of plus or minus 1%. This is both higher return
and higher risk than the umbrella company which has an average return of 3.5% plus or
minus 1/2%. This is the magical part. Look what happens
if you invest 2/3 of your money in the umbrella company and 1/3 in the bathing suit company.
WOW! Adding some of the more volatile company not only increases the average return, but
it lowers the variability (or risk). Pretty much a free lunch!
Here what it looks like on a risk-return chart. The Bathing Suit Company is up here with twice
the expected risk and return as the umbrella company. If you owned 100% of the umbrella
company you'd be here. Now if you gradually invest part of your portfolio in the more
risky Bathing Suit Company, your returns increase as you expected, but your risk, as measured
by the variability of that return, actually decreases. Owning both is superior to only
owning either of the companies. Negatively correlated companies are hard to
find and still achieve diversified investments, so we look for the next best thing: poorly
correlated investments. Recall that the price of bonds move in the opposite direction of
interest rates. But interest rates don't impact the sales of bathing suits and umbrellas at
all, and the weather doesn't impact the price of bonds. So we pretty generally say that
the stock market and Treasury Bonds are nearly uncorrelated and we get this same magical
benefit. Adding a little of the stock market to an all-bond portfolio not only increases
the returns but decreases the risk. This is precisely how it works in the real
world. Say you determined that 50% stocks and 50% bonds was the right level of risk
for you. Instead of being here like you might expect, the fact that stocks are poorly correlated
with bonds puts you here. You can think of it as less risk for a given rate of return,
or more return for a given level of risk.
What else can we do? If we take a closer look at stocks, we find out that the primary factors
that determine the outcome of stock investments in the long-term are: size of the companies,
whether they are a glamorous growth company or a less glamorous value company, and then
what region of the world it is in.
The S&P500 companies are so huge that this famous benchmark index is a good approximation
of the entire US Stock Market. It encompasses both large Value and large Growth companies.
Alternatively, choose a Total US Stock Market Index fund to further diversify with smaller
companies and to now own a portion of several thousand companies!
Stocks in foreign companies are even less correlated with the US stock market, but
are more expensive to own and have added risk from currency exchange fluctuations. Many
investors make 1/4 to 1/2 of their total stock percentage a broad international stock index
fund.
You've started a plan with goals and a saving routine that might look something like this.
In the last video you choose an appropriate level of stocks and bonds that matched your
ability, willingness, and need to take risk. That's always your most important decision.
So, here is what your target allocations might look like now.
Bonds are much simpler. You can keep the risk out of bonds by keeping them short- to intermediate-term,
and very high quality. To diversity against inflation it is popular to make half of them
US Treasury bonds called TIPS, for Treasury Inflation-Protected Securities.
Building an outstanding portfolio doesn't have to be complicated at all!
Find other explanatory videos, smart tips, and links to useful resources at FinancingLife.org.