Pass the Turkey!
I love Thanksgiving- family, food, and football. (Please feel free to rearrange that order to your liking!)
Pulling together the Thanksgiving meal is the ultimate cooking challenge. You are using the oven, the stove top and the microwave. You have foods of different flavors, textures, and aromas. Ah, nothing smells better than a cooking turkey! I am the cook in our family and I believe I will be once again tasked with pulling together the banquet.
As I started planning for the meal and all that is involved, it reminded me a little of putting together an investment portfolio. Like the meal, a portfolio contains multiple positions that act differently and serve various purposes.
Large Caps
Turkey is the big star of the Thanksgiving feast. Everyone has some and it anchors the meal. Large cap US stocks are the portfolio’s ‘turkey,’ if you will. This asset class will be the largest investment. ‘Cap’ stands for capitalization, which is determined by multiplying the stock price by shares outstanding. Large cap stocks are typically defined as companies with market capitalization above $10 billion. Often, they are companies we are familiar with like Apple, Amazon, Exxon, Coca-Cola, & JP Morgan.
Just as some favor white meat while others prefer dark meat, you have those who prefer large cap value stocks and others that favor large cap growth. The definitions of growth and value are sometimes debated but, in general, growth stocks are thought to be in companies that can grow earnings faster than the overall market- more technology, certain healthcare, and some retailers. Value stocks are slower growing, but may be paying higher dividends – often financials, utilities, and consumer staples. I like both white and dark meat and often will use both large cap growth and value investments.
Small Caps
We all know that eating our vegetables will help us live a long healthy life. (Mom wouldn’t lie, would she?) Corn is a Thanksgiving staple and we usually go with brown sugar carrots at our house. Even after I’ve bastardized the veggies with brown sugar they still occupy a smaller portion of my Thanksgiving plate than the turkey. Small cap stocks are your portfolio’s vegetables. These would be stocks with market caps of under $2 billion. They can have higher returns over large caps over a long period of time (1), but more volatility should be expected. You have unproven management teams and products. This means that, like vegetables, they may not be for everyone. If you are very risk averse maybe you skip the small caps in your portfolio. However, for many, they can add growth potential to the portfolio over time.
International
There are many ways to get your starches on Thanksgiving– potatoes, stuffing, sweet potatoes. Lots of variety. International investing also gives you different options and a variety of ways to invest. You can own large cap developed countries, which would be lots of European and Japanese exposure. You can own emerging markets like China, India, Brazil, and Taiwan. Small cap international stocks offer yet another option. And finally, you could pick funds that give you exposure to a single country.
Similar to small caps, international investing can also be more volatile than US Large cap stocks.(2) You have different cultures, currencies, and laws around the globe. Depending on the size of a portfolio and the risk appetite, I will sometimes use developed, emerging and small caps. For others, I might just use the developed markets. Either way, I usually have around 20-25% of my stocks in international investments. Despite the international markets making up 2/3 of the global markets to the US markets being 1/3, I still use less international stocks in my portfolios.
Bonds
An over-cooked, dry turkey is a Thanksgiving crisis. Gravy and cranberries come to the rescue. These dishes can often be overlooked, but if a Turkey calamity occurs they are quickly sought out and sometimes fought over. This is what I look for from my bonds in the portfolio. I want them to be boring and they support the portfolio in times of stock market corrections. Bonds are far from risk-free, but in the past they’ve moved less than stocks.(3)
Correlation is the technical term used to measure how two investments move relative to each other. A correlation of +1 means two investments move exactly the same. A correlation of -1 means they move exactly opposite each other. While nothing is perfect and a lot of factors influence the relationship, in general, stocks and bonds move in opposite directions. In recent bear markets of 2000-2002 and 2007 to 2008 the correlation was not a -1, but it still was negative, ranging from -0.22 to -0.48. (4) So when the stock market has performed like a dry turkey bonds helped out.
Commodities and REITS
I like a glass of wine while I cook (not while putting portfolios together) and wine can definitely enhance the Thanksgiving Day meal. (Everything in moderation, of course.) Commodities and REITS (Real Estate Investment Trusts) in small doses can also enhance a portfolio. The have zigged when stocks have zagged.(5) They also can be good hedges against inflation.
Dessert caps all Thanksgiving feasts. I am not always physically able to eat dessert. I am either still too stuffed or asleep. Sometimes investors don’t have different accounts options to choose from but, if they do, where you hold investments can sweeten returns. IRAs & 401ks, Roths, and brokerage accounts all have different tax treatments. When possible, hold high dividend paying and income producing investments in retirement accounts (IRA, 401ks) where taxes are deferred. Hold high growing low income producing investments in taxable or traditional brokerage accounts. The volatility often found in higher growth investments can sometimes create losses. Harvesting these tax losses in a brokerage account also add value to an investors overall return.
Just as everyone’s Thanksgiving meal is a little different, investment advisors each have their own style of portfolio construction. This is how I approach things and what I look for from different investments. I really appreciate you reading.
Now, let’s eat! Happy Thanksgiving!
1 -From 1926 through 2012, small-cap stocks averaged an annual return of 12.28 percent, compared to 10.08 percent for large cap, according to Morningstar Ibbotson data.
2- Based on 5 yr (longest comparable period) standard deviation of Vanguard All world ex-us (17.0) vs Vanguard S&P 500 (13.13)
3- Based on 15 yr standard deviation of Vanguard Total Bond index (3.52) vs Vanguard S&P 500 (13.13)
4- “The Dynamic Correlation between Stock and Bond Returns”, Thomas Chiang and Jiandong Li, March 2009
5- AssetCorrelation.com
For more information about managing your money, please visit www.frontporchfinancial.com or call (262) 236-9022.
Stock investing includes risks, including fluctuating prices and loss of principal. No strategy assures success or protects against loss.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The fast price swings in commodities will result in significant volatility in an investor’s holdings. Commodities include increased risks, such as political, economic, and currency instability, and may not be suitable for all investors.
Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.
