Your investment portfolio consists of all of your individual investments in stocks, bonds, mutual funds, REITs and other instruments. The goal of any portfolio, whether you're just starting out or have decades of investing experience, is diversity. The idea is to invest in enough different sectors of the economy so that if one investment does poorly, your other investments will make up the difference. If you have too many of your eggs in one basket, you could end up magnifying your risk. A diversified portfolio spreads the risk evenly so that no single mistake will ruin everything.
As we mentioned in the previous section, the best investment strategy for new investors with limited funds is to invest in mutual funds using dollar-cost averaging. This allows for regularly scheduled, modest contributions without incurring substantial fees. The great thing about mutual funds is that they come in all flavors, meaning it's relatively easy to pick and choose a handful of mutual funds to create a diversified portfolio.
For most Americans, a diversified portfolio should include investments in five major areas
An easy way to invest in these different sectors is by investing in index funds. Index funds are mutual funds that are diversified across a particular sector.
For example, there are stock index mutual funds that invest in the 500 largest U.S. companies, closely tracking the performance of the S&P 500. There are bond index mutual funds that invest in a diverse mix of U.S. and foreign government bonds and corporate bonds. And there are real estate index funds that invests in several different REITs diversified across the residential and commercial sectors.
By investing in these types of index funds, not only do you achieve basic diversity across the five major sectors, but the investments within those five funds are also highly diversified. That's called covering your bases.
Now that you've built a diversified portfolio, you need to balance it. Even with diversified mutual funds, some investments are riskier than others. You need to work with your broker to come up with ratios that balance the risk among your investments and that make sense for the goals you established in step one.
For young investors, most of your money will go into stock index mutual funds, perhaps 35 percent in U.S. stocks and 25 percent in foreign stocks. The rest will be split among bonds, real estate and commodities; perhaps 15 percent each in bonds and real estate and another 10 percent in commodities.
The trick is maintaining this balance even as some sectors perform better or worse than others. With dollar-cost averaging, this is actually pretty easy. Let's say that last month your stock index fund performed poorly, but bonds did great. This will temporarily throw off the balance of your portfolio, because bonds will suddenly represent more than 15 percent of the total value of your investments.
Instead of selling off some of your bond investments to bring the ratio back to normal, you need to pump more money into stocks. At first, it sounds strange to invest more in the worst-performing sector of your portfolio. But based on the principles of DCA, you get more shares for your money and keep the average cost of the investment down over the long-term.
In the next section, we'll talk about the importance of sticking to your plan.