It’s a well-established principle in investing circles that diversification tends to reduce risk. This concept is easily understood when investing in individual stocks and bonds (don’t put all your eggs in one basket). It is less obvious when considering investing in mutual funds since, by definition, mutual funds invest in a broad range of securities. After all, by simply choosing a mutual fund rather than investing in a few stocks or bonds one can easily diversify and potentially reduce risk. So, why not simply pick an index fund or a balanced fund and be done with it?

In a nutshell, the answer is that no single fund optimizes return and minimizes risk consistently over time. Paraphrasing John Bogle, Chairman of Vanguard, you can eliminate risk to capital or eliminate risk to income, but you cannot do both with a single investment. You need to balance types of investments against one another to optimize both risk and income. How do you do this? By understanding the kinds of risks presented by various investment types and then selecting investments which balance these risks most favorably in light of your investing objectives.

Of the three principal investment types, stock funds present the most risk to loss of capital. In short, there is no assurance that you will get the principal of your investment back. At the same time, stock mutual funds offer the best prospects of growth over the long term.

Bond funds, on the other hand, generally present the least risk to loss of capital, but do so at the expense of growth. It should be noted, however, that bond income is the most stable of all the investment types.

Money Funds offer superior protection of capital, but the lowest income stability because interest rates vary widely on these types of investments.

Now that you have this neatly tucked away, what should, or can you do with the knowledge? Well, whether you are choosing from 401(k) plan options or selecting funds on your own, the basic steps are to first learn about the various classes of funds and then to select a combination that fits your tolerance for risk and your investment goals.

Briefly, here’s what you need to know:

Growth and Income, Growth, and Aggressive Growth Funds have the objective of increasing the value of the amount invested over time. Growth and Income funds contain stocks of mature companies that pay dividends (the blue chips). Growth funds mainly invest in established companies who pay no dividends but use income to invest in continued growth. Aggressive Growth funds contain stocks of rapidly growing companies that pay no dividends. The more aggressive the fund, the more capital is at risk. The range of yields varies considerably between these fund types and should be examined closely before making choices.

Balanced Funds invest in stocks and bonds, plus a small percentage in cash equivalents. Balanced fund investment styles vary, with some favoring bonds over stocks (income-oriented) and some the reverse (equity-oriented). In all cases, however, the objective is to balance growth and income to optimize return at comparatively low risk. Balanced funds generally adhere closely to their chosen mix of investments over time. In one sense you can say that the balanced fund is the ideal choice since it represents a way for the average investor to hire a financial planner to manage a broadly based portfolio of stocks and bonds. Appealing as this may sound, you need to examine the composition of the fund, its expenses and its objectives to be certain that they meet your needs.

Asset Allocation Funds are a form of balanced fund with one major difference: they are aggressively managed and make significant adjustments to their mix of stocks and bonds in response to changes in market outlook. The objective is to provide above-average returns over time as compared to other balanced fund types. However, this active management style usually comes at the expense of significant turnover (which is expensive) and higher than average management costs. In the end, Asset Allocation funds may under-perform other balanced funds due to expenses alone, so one should examine these funds carefully before making a decision.

Bond Funds invest only in bonds, and their principal objective is to produce income, not capital growth. However, selecting a bond fund can be difficult. You must choose between short, intermediate and long-term. Plus, you must choose between eight kinds (US government, investment-grade corporate, investment-grade municipal and high-yield corporate among them). Finally, you need to consider yield, age of fund, management tenure, and annual cost. In the end, however, it will come down to buying the lowest-cost bond funds that meet your risk tolerance objectives.

Money Market Funds come in three basic types: those that invest in Treasury bills; those that invest in federal notes; and those that invest in what are known as corporate or bank debt instruments. Capital risk is either virtually nonexistent or very low. However, low capital risk is offset by increased income risk because, as we have all observed, interest rates vary widely over time. In the end, choosing comes down to the fee, and fees vary widely among money funds. Look for the highest quality funds that have the lowest expense ratio.

back to top

Next to credit cards, the ATM has emerged as the main enemy in our ongoing efforts to get our financial lives under control. In fact, you can probably find a dozen recently-published articles out there right now that focus on the problem and offer varying kinds of advice on what you should do. All have one thing in common: they focus on media reports that most people have trouble controlling their use of ATMs because they are such a universally available source of cash. People, it is said, misuse ATMs by accessing cash when they don’t actually need it and without thinking about the consequences. Maybe that’s true and maybe it’s not. In any case, it is certain that, just like any financial tool, we certainly need to know how to use the ATM wisely.

Here are some fundamentals to keep in mind:

An ATM doesn’t know about the checks that you wrote yesterday, or today. If you rely on the ATM to tell you what your balance is, it can cause you to overdraw your account. Overdrafts cost money.

ATMs only dispense in multiples of $20 bills, whether you need that much or not. Whatever the case, if you withdraw it you will find a way to spend it. What’s more, you are unlikely to keep a record of what you spend the money on so, if you are on a budget, you lose a measure of control.

More and more banks are beginning to charge fees for the use of the ATM. Some charge $2 per transaction, or more. If you use the ATM as a wallet, you can quickly incur substantial charges for its use. Think about it: a $2 charge on a $20 withdrawal amounts to a 10% "tax" on your money even before you spend it.

Nonetheless ATMs are a terrific convenience. To use them wisely, make sure you do at least the following:

1. Keep your checkbook up-to-date; don’t rely on the ATM to do it. Sign up for overdraft protection just in case.

2. Plan your cash needs and try to develop the habit of making a withdrawal only once a week. Better still, get cash back from your weekly grocery shopping when possible. There are no ATM fees when you write a check.

3. Find out from your bank if they waive ATM fees when you maintain a certain balance in your account. Keep at least the minimum in your account.

4. Beware of charges to use another bank’s ATM because these tend to be the highest of all.

back to top

Our choices will be influenced, however, by our built-in biases toward risk. Some of us are risk takers, some are not. That’s the irrational view.

From our twenties to somewhere in our fifties we can be considered to be in the accumulation phase. During this period our needs for current income are usually satisfied by our jobs. This makes it possible to concentrate our investing in types of funds that have growth as their primary objective. This generally means that we will invest mostly in stock funds. In the earlier years we are likely to choose aggressive growth funds and index funds as our primary vehicles, knowing that the risks will be reduced over our long investing horizon. During this phase our tolerance for risk should be fairly high.

From our mid-fifties on, however, and particularly in the final five years or so of our working lives, our attention will shift to preserving the capital we have accumulated. Our long horizons have vanished and market risk becomes a significant consideration. During this period we are usually best served by moving most of our investments to balanced funds, bond funds, and cash equivalents. Such funds concentrate more on preservation of capital and generation of income, at the expense of growth. We can say that during this phase our tolerance for risk should be decreasing.

The following matrix gives us an indication of the various levels of risk we might expect from selecting different combinations of stock and bond funds. Using history as a guide, the matrix illustrates 20 and 30 year average returns for the market ending in 1993. We have excluded the unprecedented returns of recent years because they are not considered to be generally indicative of what can be expected over the long-term.

In addition, we can see from the "Loss Possibility" column what each combination experienced during the "crash" of 1973-74. To offset that dismal result, the "Recovery Rate" column shows what each combination gained in value over the four-year period ending in December 1976.

From these statistics we can see, for example, that the most conservative portfolio of 80% bonds lost less and corrected faster; but, over 20 years it accumulated about one-third less money than the 100% stock portfolio. As you are assessing your tolerance for risk, keep this matrix in mind. Ask yourself how you would feel in a major market downturn? Would you be willing to lose 32%, as the 100% stocks portfolio did, if you stood the chance to accumulate 50% more money in 20 years than your other choices? Do you have the time to recover?

Whichever phase you’re in, make your preliminary fund selections according to the rational view. Then look at them in light of the matrix below and your feelings about risking your money. When you have adjusted your choices to a portfolio that you think you can sleep with, you have established your tolerance for risk.

back to top

back to top

More and more employers are offering FSAs (Flexible Spending Accounts) to their employees these days. These accounts permit you to set aside a fixed amount of your income tax-free (not tax-deferred as with 401(k) plans) to pay for certain medical expenses that are not covered by your medical insurance, as well as dependent daycare expenses.

People normally use this money to pay for medical and dental deductibles and excess premiums, prescription eyeglasses, dental care, prescription drugs and day care costs.

Since the money is never taxed, Uncle Sam effectively pays some of your medical and daycare costs. The drawback is that you must spend all you put aside annually or lose it. So, you need to plan carefully.

back to top

back to top