Wellies for Rainstorms and Small-Cap Investing. These Are a Few of My Favorite Things.

I’m a space freak. No, I’m not a Trekky or a wannabe Jedi, I just always feel a need to have more, tangible space.  If you have seen my room, please note that I did not call myself a clean freak, so don’t try to refute me on this one. In fact, the reason why my room is so messy is because I am constantly lacking the space I need.  So, every few weeks, I ignore the hoarder in me, and try to purge my closet of items that I can’t imagine wearing again.  For example, those spaghetti strap sun dresses that the adult-Serena couldn’t possibly wear again, or those ugly rain boots that everyone had to have a pair of in 2006. As I start throwing these items into the middle of my room and make excuses for why everything needs to go, I begin to think: “or will I actually wear these again?”
 

At this point, I get all sentimental and start thinking about the reason I purchased the boots in the first place.  Rather than think about how unfortunate the rain boot trend was (really), I relish the memory of being able to sop through my all-terrain walks to class without a care.  Or I think about the time my parents paid me $100 to shovel the snow out of our driveway because I was the only one equipped with the proper footwear.  As I go through each floppy sun hat, each pair of boots, each sundress, etc. I realize why they were once important to me, and why they serve a purpose every year.  Then, I fold them neatly back into their designated area, and shudder as I realize I’ll never be able to make more space for myself.  However, why make room when everything you really need is already in your closet? Please note: It took a deep suppression of the shopaholic in me to make that statement.

It is easy to get all worked up about the surplus of winter coats and scarves in your closet when you’re in the middle of a summer heat wave, same reason you re-evaluate your need for shorts and bikini tops when you are struggling to stay warm during the winter freeze (and Katy Perry’s California Girls has ceased existence on the radio).  You have to remember that a lot of the things you own are there for a reason, even if short term circumstances don’t warrant their existence.  Similarly, this is how you should view your investment portfolio.  Part of being a passive investor is to own a portfolio that is highly diversified and essentially “owns the market.” 

A great way to start this type of investing is to make sure your portfolio owns stocks and/or bonds from different asset classes in both the United States and around the world. Let’s first look at the region of your investments.  To start, keep your international exposure limited to “developed countries” like Australia, Japan and the UK.  For investors who can withstand more risk, and have a higher time line to invest (usually clients who don’t need the money for at least 10-15 years, or clients who can withstand portfolio volatility – I’ll touch on this in a later post), another type of investing is that in Emerging Markets.  These are investments in countries that are not considered “developed,” yet, but still have economies large enough to foster growth and investment (like China and Brazil).  For these reasons, Emerging Market investments are risky, and correspondingly, they have produced higher returns in the past. 

In addition to diversifying the region of your investments, you should further diversify into different asset classes.  For example, there are different asset classes categorized by company size and type: Large Cap, Mid Cap, Small Cap, Value and Growth.   Non-stock or bond assets such as Real Estate Investment Trusts and Commodities funds are great diversifying assets, as well.  Investing in actual real estate (houses and apartment complexes) or commodities (gold and grains) helps diversify your portfolio, also.  But, really, who wants to store barrels of rice in their garage and have to deal with eventually selling them to buyers?  Investment trusts and funds do the hard work for you; all you need to do is provide the investment capital to participate.  The more diversified your portfolio the better.  And even better if the assets perform in an opposite or a negatively correlated manner (I will touch on this in a later post, too).

You might be wondering the point of having all of these investments, and whether or not you can afford to diversify given your amount of investable assets.  Yes, the size of your portfolio will affect your diversity level, but there are many funds available that diversify for you.  Each mutual fund will own a mix of domestic and international stocks from different asset classes.  Hence, the diversification is built into the fund, and all you need to do is buy and hold it.  And why should we diversify our investment portfolio? Let’s first think about the diversification already happening in your closet.  As I once determined, even though my rain boots seem like the ogre in my closet all spring and summer, once fall and winter roll around, I’m thankful I kept them. 

Aside from the predictability of the seasons, you never really know when you’re going to have a freak rain or snow storm (I’m in Seattle.  So, the possibility of this is 100% no matter what the season).  This is exactly why I have my rain boots, and the randomness of the market is why I’m diversifying with asset classes like Emerging Market stock and US Small Cap Value stocks.  No matter how unappealing those boots, or those investments look during certain times, they are there to help you weather both financial and literal storms.  Same thing goes for my 50 tank tops.  Aside from an acknowledged excessiveness of spaghetti strap tops, I know that there will be those freak summers where I sweat through everything I own before the end of the day.  And for this reason, I keep them around another year.

You never know what the weather will be (and, I’m just assuming you don’t live in Antarctica.  If you do, congratulations on finding some internet).  Just like how you never know how the stock and bond markets will perform.  One year, US Large Cap stocks could be the top performer, and commodities the worst.  But the next year, commodities could have the highest returns, while all stocks decline.  Because of this randomness in returns, you can protect yourself by owning a little bit of the entire investible market available.  That way, you can participate in a general market return, as opposed to that of just the winners or the losers.  If you are thinking, “why not just buy the winners and sell the movers?” Think about how you did the last time you were at a casino, or the last time you played a game of chance.  It’s all about luck, and I don’t know if you would be willing to pick the “winner,” or essentially gamble on your portfolio.  Would you put your house on the line for a horse race?  Like your house, your portfolio should be viewed as an asset and a safety net.

The smart way to invest, is to bet on the sure thing.  And the sure thing is: we don’t know. No one can predict with certainty what will outperform and what will underperform every year.  The best thing to do is diversify your luck as opposed to sticking with one stock or asset class that has a small chance of generating net positive returns in the long run.  No one would only own a pair of sandals and simply hope that it never rains or snows.

So, before you chuck those pair of chucks (ha) or sell off your US Small Cap positions because Large Cap stocks are booming, think about the reason you own those shoes, or those investments in the first place.  Look at how those items fit into your life with a long term perspective, and with diversification in mind.  Stop obsessing over what needs to go now, and enjoy whatever life (or the market) presents to you.  Once properly diversified, your closet and your investment portfolio will be ready to face the randomness that is life.