Over the past number of years I have come to really enjoy cooking. It unknowingly led me to an analogy for investing that is simple to understand and better yet, visual. The analogy, consisting of ingredients and the underlying recipe, has helped hundreds of investors better understand what they can ‘control’ within their 401(k). Furthermore it helps investors understand confusing terms such as “diversification” and “asset allocation” and how they impact the ‘behavior’ of their portfolio.
Step #1 – The Stylebox
The image to the right represents the entire US stock market compartmentalized into nine boxes. The idea is you do not want to compare funds in one box to funds in the other box, as they are each investing in distinctively different types of stocks. The market says diversify, diversify, diversify — but people get confused with what that really means. The visual aspect makes it easier to identify any gaps in your portfolio, would be issues with your portfolio’s diversification. (NOTE: This is ONLY illustrating the US Stock market, so also included is international stocks, bonds and cash. For simplicity sake, we are going to stay focused on the US stock portion of an investor’s portfolio.)
Step #2: Diversification / Ingredients
If you look at each of these boxes and the funds inside them as ingredients, diversification is simply making sure you have enough ingredients to complete a recipe. As you can see, funds rarely fit neatly inside their respective ‘box.’ In fact, the vast majority do not. Additionally, even though these are listed as US stock funds, a significant portions of these ingredients can include international stocks, bonds and cash. And finally, just as the Papa John’s commercial says — better ingredients, better portfolio.
Actual Portfolio Diversified Portfolio
Step #3: Asset Allocation – The Recipe
Now let’s say we have all of the ingredients we need to cook a pizza crust. Depending on the recipe we use and process used to cook it, the ingredients could result in a pizza crust or — a saltine cracker. We could use the same ingredients, but have two entirely different outcomes.
Investing is no different. In fact, studies have shown over 91% (Brinson, Singer, Beebower, 1991) of the reason for your portfolio’s performance is specific to the recipe used.
Therefore, there are reasons your portfolio has behaved the way it has over the past few years. It has to do with the specific ingredients (investment funds) used and the percentage put in each fund. Based on the investor profile you completed, we simply need to create a recipe that fits that specific level of risk. Does that make sense? (I know it doesn’t add up to 100%, the remaining portion is in bonds and international stocks)
Actual Recipe Proper Recipe
Decision: Do-It-Yourself, Get the Recipe (Advice), or Have it Cooked For You (Account Management)?
Just because I walk into a fully stocked kitchen with every tool and ingredient I could want, it does NOT make me Bobby Flay. Therefore, having a professional either provide you the recipe (401(k) advice) or simply cook it up for you (401(k) account management) can be better options than trying to do it yourself.
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