Here comes another question, this time from a patron:
Quick question: my current stock allocation is 100% in the stock market. I have been told by a friend who is an analyst at a bank and by people online that I should diversify into bonds and preferred shares. What do you think about that? Also, all my stocks are North American, should I invest in European + Asian securities? Thanks, huge fan!
Generally speaking, yes, you should have 100% of your money invested into stocks. Investing in oversea companies is almost entirely pointless because the best companies are in the United States. The benefits of investing in foreign markets is minimal for any portfolio under $10M or so.
As for bonds, you can throw them out of the window right away: they are beyond useless. Lastly, preferred shares are inferior to common shares 95% of the time. Yes, there are times where preferred shares are better investments (particularly when they come with the right to convert them into regular shares), but that’s a minority of the time. In my entire trading career, I have never, ever bought preferred shares and I have invested exactly one time into bonds.
PLEASE NOTE THAT THIS ADVICE APPLIES TO INVESTORS AND NOT TO TRADERS.
There is zero point investing into oversea companies for the average investor in the United States. There is almost zero point investing in Canadian stocks for Americans neither. First, the best companies are and have always been traded on American markets; even Alibaba, one of the few outstanding foreign companies, trade on the US stock market. I can think of maybe 5 foreign companies that I would like to invest in and all of them trade on the US stock market as secondary listing (i.e. they trade on their main market, whether it’s CAC40 or DAX, and in the US under a second ticker as well).
Investing overseas also exposes to currency risks, which you will mostly want to avoid, and a risk that is difficult to manage without a small fortune (too costly). For instance, say you invest in a company in the UK and the british pound loses value. You’d lose some money even if the company did go up.
Investing overseas provides some advantages, one of the most frequent being “diversification.” However, as a small time investor, you do not need that kind of diversification. Plus, I never truly understood how investing in another country reduced your risk anyway: if the US fall, the rest of the world will fall with them anyway.
Lastly, it could be said emerging markets provide higher returns. But this comes at the price of an incredible risk: just ask people who invested in Venezuela. If you want higher returns, simply devote more of your portfolio to small caps, quality, growing companies.
There is no point to invest overseas unless you have a major portfolio; then and only then can you perhaps devote $500,000 to foreign companies.
Trust me: there are plenty of good companies to invest in right here in the United States.
There would be a point in buying bonds if interest rates were high. They’re not and they might not be high ever again. A typical bond pays 2% today, which is a joke. Some bank accounts pay more than that. Plus, bonds are not necessarily safer than stocks and I could even argue – against the general motto of the financial world, I admit – that they are more risky. They are more risky because if a company is in real trouble, your bond will default and you’d be lucky to get half your money back. Half might be better than $0, which is what you get when you have shares of a bankrupt companies, but the facts remains that you are accepting a very low rate with zero chance of growth, so why bother? Plus, bonds default all the time. Look at this:
This is Aberdeen Asia-Pacific Income Investment (TSE:FAP), the only bond fund I own. I bought it in the low $4 and it pays a 8% yield at the moment, which has been cut several times before. Sure, those are some higher-than-average risk bonds, but you get my drift: bonds are not necessarily safer. Just look at how AGG, the highest-quality bond fund in the world (listed in the US, of course) fared in the last five years:
-2% while market is up 70%. And the SPY pays a higher dividend than AGG, so why bother with that crap?
Also, you should know bonds’s yields are usually fully taxable as interest income, meaning you’ll pay a ton of taxes on them. No thanks.
“But but but muh financial crisis!”
If you’re that worried about a major crisis, invest in defensive stocks paying high dividend. You’ll earn more than with bonds and you’ll also get growth. See graph above.
“But but but giant crash! Lose everything!!!”
If there really is a giant crash, bonds will default as well. Keep your money under your bed or, better yet, buy gold because money will become worthless. Actually, buy food+weapons.
Look: bonds belong to big portfolio and some very specific types of portfolio, with very specific objectives. Yes, if I did manage a pension fund, I would buy bonds, but for individual investors, forget it.
QUICK NOTE: For traders, it’s possible to use strategies to earn a much higher yield with minimum risk (mostly using margin). However, this is beyond the scope of this article.
I won’t lie, there are preferred shares worth buying, but they are rare. Back when I was with my old brokers, I was offered a new emissions (i.e. new shares) preferred shares on a company at a significant rebate. Say ABC traded at $10.00 and paid no dividend; I was offered privileged shares at $9.50 AND it came with a 6% annual yield plus the option to convert that privileged share into a regular share at any time. This is an outstanding offer (I’ll explain why in a later article) and I jumped on it; unfortunately, by the time it was my turn to buy, the offer was fully funded.
However, that kind of situation is rare and in 95%+ of cases, you are better off buying the regular shares instead. Here’s why:
- Privileged shares are less liquid and harder to buy or sell
- Privileged shares distribution will never, ever grow
- Privileged shares will never gain in value (the price might go up and down, but since you are not entitled to any share of the profits of the company, you will never get true growth). The example above was an exception.
- Most of the times, the privileged shares can be called back, meaning the company can buy them back after a certain period of time, and your yield is gone.
- Speaking of the yield, if the company does really, really bad, the yield is a goner as well.
Preferred or privileged shares do not advantages, but again, they apply to a very limited subsets of investors and/or major funds. For instance, a major insurance fund might be limited to 50% shares, meaning it cannot invest more than half of its money into shares; buying preferred shares might be a way to dodge that requirement.
Again, maybe you found some really interesting priviledged shares, but most of the time, you are better off with regular shares. Oh, and privileged shares are fully taxable as well – no tax credit for yield.
As an individual investor, 100% of your money should be into stocks, period. There’s no point buying anything else. Well, a hundred percent of your investinge money, of course. Nothing wrong in keeping some cash around. There are, however, a few exceptions I’d to bring out to that rule:
- You are retired and absolutely need the income or else you die. Like, you need that $5,000 per month or else your life is over. Then again, I would recommend safe, high-yield stocks (many stocks did not even cut their distribution during the financial crisis, so…) over bonds or any of that crap. Still, if you really must have that income, then it makes sense to go for fixed income. Just realize you’d be far better off investing it all into stocks and selling whenever you need money (or investing into McDonald’s, AT&T and so on, which have safe distributions).
- You literally cannot sleep at night because you are too stressed about your money. Then, invest into governmental bonds and stop crying. You’ll earn 0.5% per year but the risk is infinitesimal.
- If stocks crashed 30%, you’d have a break down. If you’re not ready to lose 30% of your money, don’t buy stocks. Not even mutual funds. Just realize that you do not take a loss until you sell and if you buy quality stocks and diversify well, your odds of losing money over the long term (and your odds of underperforming bonds) are pretty much 0.
Last tip: as a matter of fact, you probably don’t want to invest more than 5% of your money in a single stock, and even 5% is high. I’d only invest 5% in companies I completely believe in (such as AAPL, BABA, etc). A 3% figure seems more reasonable to me. That would imply around 30-35 companies, which seems very solid. You’ll want to invest into various sectors (I did talk against diversification earlier, but there’s some you should do and some you shouldn’t; investing across sectors is one of the things you should do), such as technology, restaurant, real estate, industrial, blue chips, etc. With that, it will be very hard for you not to utterly demolish any kind of mixed portfolio strategy over any long period of time.
Update (5/6/2017): Someone asked me right after I published this article why I had included the “this doesn’t apply to traders” disclaimer at the beginning. Well, as a trader, you might end up buying bonds and you most likely will. Bonds will most likely be an important part of your trading strategy.
Say for instance you decide to short NYSE:ANGI. You sell 10,000 shares at $10 and you obtain $100,000. What do you do with that money? Well, you could leave it there, and some times you would, but you could also decide to invest it into AGG (a major bond fund) or something. That way, your $100,000 will earn you 2% per year. And if you need to close your ANGI short, you can resell your bonds at a minimal loss of value, if any.
If you had invested the money into stocks instead, well, the stocks you invested in could lose value. Imagine a scenario where ANGI keeps going up and the stocks you just bought with the money from shorting ANGI keep dropping; now you’re facing a tough dilemma, a problem that is avoided entirely by buying bonds instead. As a trader, you will end up with bonds if you seek to maximize your return.