Understanding the Basics of Investing
In this final part of our guide, we aim to discuss how to construct a well-diversified investment portfolio tailored to your risk tolerance, maximizing potential returns.
There are essentially three ways to invest your money:
- Lending your money to someone else in exchange for interest. This includes government and corporate bonds, among other options.
- Investing in a business. This encompasses purchasing stocks from publicly traded companies and real estate (owning a property and renting it out essentially makes you a business owner, though real estate is sometimes viewed as a distinct asset class due to its nature and performance variations depending on the economic cycle).
- Owning assets with potential to safeguard your purchasing power and/or appreciate over time with low correlation to the previous two categories. Examples include gold, various metals, art, commodities, and cryptocurrencies.
These three major asset classes do not perform similarly during growth or recession periods. Sometimes, when stock prices fall, precious metals appreciate, though this is not always the case. There are instances when different asset classes move in the same direction, albeit with varying magnitudes.
Determining the Right Asset Allocation
Before selecting specific investment instruments or locations, it’s crucial to determine the appropriate proportion of these instruments based on your objectives and risk tolerance.
For instance, in the United States, a common portfolio is known as the “balanced portfolio,” consisting of 60% stocks and 40% intermediate- to long-term bonds. Historically, such a simple portfolio has yielded impressive dollar returns with an acceptable level of risk. This can be efficiently replicated in Mexico at low costs by purchasing ETFs through an online brokerage that only charges a transaction fee, without additional costs for online information, custody, management, or portfolio administration.
Moreover, investing in global assets (not just U.S.-based but also incorporating stocks from Europe, Developed Asia, and Emerging Markets) can enhance returns and slightly reduce long-term risk. This applies to both stocks and debt instruments, providing some currency exposure and diversification.
In certain cases, incorporating speculative assets with appreciation potential like gold, art, or virtual assets can further mitigate risk due to their low correlation with other asset classes. However, it’s essential to monitor this as correlations are dynamic and change over time.
Finding the Optimal Asset Combination
Now, how do we begin? How can we find the most suitable combination for our specific situation?
Fortunately, it’s not as challenging as it may seem. Numerous Nobel laureates have published their investment portfolios in various books, providing a solid reference for constructing your own. Numerous websites compile these portfolios along with risk and expected return metrics.
Additionally, free tools allow you to backtest your own portfolio and compare it numerically and graphically with others, revealing past performance, volatility, and maximum historical decline during crises.
However, it’s important to remember that historical data and statistics only serve as a reference framework. Risk metrics and expected return are derived from these data points, helping us understand what to anticipate. Yet, they do not guarantee future performance.
Experts assert that while history may not repeat itself, financial markets often exhibit patterns, rhythms, and cycles that tend to recur, albeit with varying durations and characteristics.
Key Questions and Answers
- What are the primary ways to invest money? There are three main methods: lending money and receiving interest, investing in businesses (stocks or real estate), and owning assets with appreciation potential like gold or art.
- How do I determine the right asset allocation for my portfolio? Consider your objectives and risk tolerance before deciding on the proportion of stocks, bonds, and alternative assets.
- What is a balanced portfolio? A common U.S. investment strategy consisting of 60% stocks and 40% intermediate- to long-term bonds, historically providing strong returns with acceptable risk.
- Why should I consider global investments? Global asset allocation can enhance returns and slightly reduce long-term risk by providing currency exposure and diversification.
- How can I find the optimal asset combination for my situation? Utilize resources like published portfolios of Nobel laureates, backtesting tools, and comparing your portfolio with others to make informed decisions.
