What to do with your money, Part II

Once you've taken care of the short term, how do you go about building a portfolio, and what instruments should you use?

First things first. You should take a survey that allows you to asses the amount of risk you are willing to bear. There are numerous surveys available for free to help you do this. Here's one from T. Rowe Price, http://www.troweprice.com/common/indexHtml3/0,0,htmlid=904,00.html?rfpgid=8283

They mostly ask about your time horizon and your appetite for volatility. In other words, if you come home from work and find out that the Dow was down 5%, are you going to freak out?

Let's walk through the basics to portfolio construction. In the next post, I'll talk about how to understand and interpret the market.

I'm going to assume the long term here. In other words, I'm assuming you have adequate savings, and have paid off high-interest bearing debt.

Let's say after taking a survey, you (via the survey) determine that your asset allocation should look something like this: 50%Large-Cap U.S. equity, 15% Mid-Cap U.S. equity, 10% Small-Cap U.S. equity, 20% International Equity, 5% bonds. Now, let's stop there. What does all of this mean? 'Cap' stands for capitalization. This is calculated by taking the price of the stock and multiplying by the shares outstanding.

Large-Cap Companies: These are the largest companies in the world, i.e. Wal-Mart, Exxon, etc.
Mid-Cap Companies: Smaller than the large-cap and generally lesser known. But they are still huge. Examples include Starbucks and Abercrombie and Fitch.
Small-Cap Companies: Smaller than the mid-caps and fairly obscure. Still, they are very large with several hundred million in annual revenues. One semi well-known company is Ann Taylor (if you're not married, you probably haven't heard of it)
International Companies: Don't let these scare you. Most of these are very well-known in the U.S. Some large international companies include Toyota, Nikon, Rolls-royce, Bayer, Daimler, and Nestle.

Wait a minute, can't international companies be broken down further into large, medium, and small? Yes, but for simplicity, I will not do that here.

How do these categories react? Well, what you should be more concerned with is how they react to one another. In other words, if large-caps get slaughtered, will small caps as well? And if it's a bad year in the U.S., will my international portfolio also get slammed? That's the whole point to diversification, it isn't necessarily adding a ton of different holdings, but adding ones that do not correlate with eachother. How many times has the U.S. been the number one performing economy? Never! That's the argument for having exposure to international companies.

Tools to use

Mutual funds (I'll suggest some hybrids in my next post so don't run out and buy anything yet) make the most sense in trying to build out your portfolio. Why? Going back to my previous post, you can purchase one mutual fund that will hold 100 large-cap companies (or mid-cap, or small-cap, or whatever). If you want nano-tech in India, there is a mutual fund for that. If resources are tight, you could buy one mutual fund for each type of asset class and be done. Now, for this, the average mutual fund will charge anywhere from .5% to 2% a year, with small-caps and international stocks on the higher end (reason being more research goes into those asset classes). I'm being very general here, I will explain more in the next post, but this will do for know. I like morningstar's website the best (www.morningstar.com), you can register for free and get great information and search available funds.

Why I'm not a stock picker

Again, greater detail will be forth coming, but, in general, I'm not a stock picker and I don't think others should be. To be able to properly assess whether or not you are buying a company that is fundamentally worth more than the market is pricing it at (for this is the premise to picking stock of an individual company) you would have to know how to properly conduct a company valuation (which most people can't do) and have a very good grasp on intermediate to advanced accounting issues to locate potential trouble spots. And even if you could do that, the chances of you knowing something that hords of Wall Street analysts don't already know (when they travel in their Jet to meet with the CEO), are slim. Most likely, they've already priced the stock accordingly. This is called the "efficient market theory." Which says, the greater the transparency (the U.S. market is highly transparent, almost to a fault), the higher the efficiency which means the less likely it is that you will uncover something the "market" did not six months ahead of you. Does that mean the opposite is true (i.e. emerging markets)? Yes, now you are beginning to understand. I'll save advanced portfolio construction for the next post.

So what do we know now? We know that, taking a longer time horizon, we should have our money spread across multiple asset styles in order to hold assets that do not correlate with eachother or have a very low correlation. And, the quickest way to obtain excellent diversification is through mutual funds. And that I've deferred the 'meat' of the discussion until next time. Take a look around at some of the websites, it might make the next post more meaningful.

Now we have a basic introduction to portfolio construction.