I show people that if they have no idea what to do with their money and they're saving for retirement and they have 10 years or more to go until retirement or even if they're on the verge of retirement and they won't get nervous if the stock market goes down, they could just divide their money up, putting 60 percent in a total stock market index fund and 40 percent into a total bond market index fund. If they did that alone they'd be ahead of most Americans.
Not every 401(k) lets them do that. They might not have a total bond market index fund or a total stock market index fund. The key word for stock funds relates to size. There are three words that relate to size: large, small and mid. Large is just a simple way of telling you that that fund is only going to pick stocks in very large companies like Microsoft, General Electric Co., Exxon Mobile Corp., Wal-Mart. Small means they're going to pick stocks in very small companies. Mid means they pick the stocks of medium-sized companies, those that aren't really large or really small.
You want some of each of those because each of those stocks will act differently when the stock market goes either up or down. When you have some of each, that's what's called being diversified.
You should also note international (stocks). You would invest some of your money in the United States and some in other countries, because the U.S. stock market and the stock markets in other countries act a little differently from one another. So when the United States stock market is climbing, maybe it's not climbing as much as the international markets. But maybe when it falls, the other ones would be the buffers.
International stocks can be more volatile, meaning they could maybe climb more, but also fall more, and so people get nervous. Because of that, most managers don't say go 50-50, they say (invest) maybe 25 (percent) or 30 percent of all your stock money into an international fund that would invest very broadly in many international stocks.
The average international fund is up about 29 percent in the period from the end of June last year to the end of June 2007. It's up about 29 percent versus the average U.S. stock fund, which is up about 19 percent.
“The trouble is you don't know when winter is going to come when it relates to the market.”
What happens way too often is that people see the international fund and they say, "Well, that's the winner. It's up 29 percent. How can I lose?" What they don't realize is that the market is always operating in cycles, just like the seasons change from summer to fall to winter.
The same thing happens with parts of the investing world. The fact that international funds have been the winner the last year doesn't mean they're going to stay that way. They take turns, not necessarily predictable turns. International funds won't always be up 29 percent (per) year. The trouble is, you don't know when winter is going to come when it relates to the market.
Your protection, since you don't know when it's going to come, is to divide your money into those different types of mutual funds. You have some money in bonds, and the classic would be a 60-40 split -- 60 percent in stocks and 40 percent in bonds. Then you'd divide the 60 percent up with 25 percent of that into international funds and then taking the U.S. stock money and dividing that up 75 percent into large-stock funds and 25 percent divided into small-stock and midcap funds. That would be it; that's what you could do.
Now, if you're younger, usually a 60-40 (split) is too conservative. That's a good mix for people in their 50s that are starting to approach retirement. Or someone who gets really nervous if the stock market goes down; that's a good mix for them.
But if you're very young, you need to make your money grow. (Because) the stock market, at least based on history, goes up about 10 percent (per) year, and the bond market goes up about 5 percent (per) year, you need to get that better growth from stocks. If you're in your 20s, some advisers would suggest that you put everything into stock funds.The way you cut your risks is you don't just choose one stock. Chances are if you choose one stock that you won't win with it. You have many types of stocks and that way, your chances of winning are much better and you always have winners and you always have losers, and the winners buffer the losers. That's why you do diversification. If you pick one stock, you don't have that opportunity.