Now that we have a deeper understanding of the three ways to invest our money and the role each of them can play in an investment portfolio, it’s worth talking about how we can put all those pieces together. But let’s remember:
Debt instruments involve lending our money to an issuer (a government or a company) who promises to pay us periodic interest at a rate that is usually fixed (but can be variable) and return the principal to us over a specified period. They are only as safe as whoever issues them.
It is difficult for a strong government like the United States, Japan or Switzerland to default on its debt payments, but it is not impossible. Or companies like Apple, very solid financially and with a lot of cash on hand. Countries like Mexico have a higher risk, others like Venezuela a fairly high risk.
On the other hand, they generate a stable income for us (the payment of interest). However, in many cases it is less than inflation much of the time (although there are instruments that protect our capital against inflation, such as the Udibonos in Mexico). Issuers, like us, want their debt to have the lowest possible cost.
Debt instruments are also traded daily on financial markets, so their price may fluctuate. The short-term ones have very little volatility, because they will expire very soon. But the long-term ones can present an important variability, although statistically much less than that of the actions.
Investing in businesses, on the other hand, means owning companies that are leaders in the market, or that are breaking paradigms. They are responsible for innovation, technological development and global economic growth. The mission of any company, in the end, is to maximize the return of the people we invest in them.
If it were more profitable to simply earn interest on debt instruments, no one would take the risk of setting up a business. That means: they offer a higher potential return in the long term and that is why everyone, including the most risk-averse, should include them in their portfolio, even if it is a small percentage. But they have a big disadvantage: the share price can have very sharp variations in short periods.
The idea of building an investment portfolio, as we have already discussed, is to first control risk and then maximize return. We must be very clear about our risk tolerance, which means knowing how long we can withstand drops in our portfolio without getting nervous.
So, a very conservative person, with a very high risk aversion, could not bear to have a large percentage of their money in company shares. He is someone who prefers to see his portfolio grow slowly but surely. He can tolerate some volatility, but not too much. In that sense, his portfolio would be concentrated mainly in debt instruments with different terms, with a small percentage in shares, which allows him not only to preserve the purchasing power of his money, but also to increase it. An example of a conservative portfolio might be 90% debt instruments, 10% equities.
An extremely aggressive and experienced person, who is comfortable with volatility because they have lived it and understands that it is part of the game, could have a totally opposite portfolio: 90% in stocks, 10% in debt instruments. This would be a high risk portfolio. It is worth noting that even the most aggressive person in the world should have at least a small portion of her portfolio in short-term (highly liquid) debt instruments.
When the markets go very bad, interesting opportunities can present themselves. If in times of crisis we have everything invested in stocks (which have fallen precipitously) and we do not have cartridges available, we will have no way of taking advantage of them. We always need to have some flexibility.
We’ll talk more about portfolio construction in the next installment.
Personal Finance Coach
Senior executive in insurance and reinsurance with strategic business vision, high leadership, negotiation and management skills.
He is also a Personal Finance columnist in El Economista, Personal Finance Coach and creator of the page www.planetusfinanzas.com