The idea of diversification is to spread out your risk, so that when one part of your investment goes down it does not necessarily mean all of them will.  Asset allocation is how much of your assets you spread between different investments.  Since I am focused on retirement accounts for this article I will choose to ignore your house, possessions, automobiles, etc.  Focus on money invested in accounts reserved for retirement.

The big basic choices are stocks, bonds, and cash type investments.  Of course there are other types of investments, and there are many segments in every type, but we’ll make another assumption that we want simple and we want to track the broad markets.  The next step, after defining what we are working with, is breaking down between the choices.  To keep it simple we put a large chunk in stocks, a small chunk in bonds, and an even smaller chunk in cash.  The idea is to match the broad markets.  As you approach retirement and move through it you shift assets from stocks to bonds and cash.  That is simple asset allocation.

Of course once that is said and done most people believe they should diversify further.  They pick market segments they believe will beat the market, or choose between value and growth, or invest in different international markets.  Those are all valid strategies.  The problem is the reason people choose those investments and the arguments they use against other strategies.  It’s funny that most of this strategy is done based on past performance and expected future performance, but always with the warning that none of that guarantees future results.  It’s funny that “matching the market” would generally mean investing in a total stock market fund and leaving it at that.  It’s funny that performance of a total stock market index, over the long term, are considered one of the the best standards and benchmarks.  I guess going forward that just might not be good enough for some people?

First, is this a surprise?  Food and energy prices have been racing up.  Health-care costs continue to climb.  Core prices have also moved up steadily.  As rate cuts were made to smooth the economy there were little side notes in the discussion questioning when it would all add up to higher inflation.  I believe the question was always when, not if, so should not be considered a surprise.

Second, is this a problem?  The popular opinion of the Fed’s comfort level suggests 1-2%.  What if they are willing to put up with inflation up to 3.5% for a while?  If inflation gets out of control it is a problem.  Until then, the bigger question is how realistic are inflation numbers.  If most people are experiencing personal inflation approaching 4% is it really a problem if the official reading says 3%?  I don’t believe it is a problem.  It is a real concern that needs to be included in your plans.

Somehow I still feel like I’m behind.  One big reason is this site.  My goal was really to get some good information up here every couple of weeks.  I also want to create new plans instead of just following my old ones.  Instead I am putting up a lot of insight into how I react to news and how I plan investments.  That’s old to me though, even if it is new here.

Maybe I’ll have to make some real goals for myself in this area…

It’s funny, headlines yesterday pointed to Buffet’s move as great for the markets.  The first thing I thought was that it has to be great for Buffet, but that means it’s not so good for someone else.  Apparently he wants to re-insure municipal bonds for several companies who are possibly in trouble.  Due to financial policies and credit rating systems these companies need to have a certain amount of cash available according to the risk of their portfolio.  I guess Buffet believes that they are in a bad enough position that he can take the best big chunk of bonds from them.  They have to decide if giving up the fees he wants, and the bonds he wants, leaves them in a much stronger position.  One company came out very soon after I saw the news and rejected it.

What can we learn from this?  The biggest lesson is understand your position.  I believe timing investments is smart if you can handle it.  Buffet, Microsoft, and Blackstone Group are all trying to do it again.  But they are in great positions.  Billions in cash.  Finance, accounting, legal, and management teams working with them.  They will not only make investments, but take control.  It’s a lot easier to make money when you have a lot of money already.  Fees take a percentage off your investments.  That fee percentage will be a lot smaller on $1M than it will on $1k, so a larger investment can make a profit after fees quicker than a small investment.

If you had a billion dollars and real time access to Buffet’s financial moves what would you do?  Would you make the same moves as him, invest in Berkshire, stick with index investing, or be happy to preserve it and go more conservative?

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This article describes changes coming to the Dow index. The index will drop Honeywell and Altria to pick up Bank Of America and Chevron.  The changes will be in effect next week.  The index isn’t actively managed, does not have a lot of turnover, but at this point in time there is an impact in changing a large portion of investments.  This is what happens with smaller or targeted indexes.  To truly track the broad market there are larger indexes such as Vanguard’s Total Stock Market Index.

Here’s a quick highlight of the companies involved in this change.

Altria was formerly Philip Morris.  It is primarily a vice stock, tobacco, but still owns other operations.  It has a market cap of $154B, a PE ratio of 16.59, and dividend yield of 4.13%.

Honeywell is a technology and manufacturing company with worldwide sales and diverse product lines.  It has a market cap of $42.6B, a PE ratio of 18.08, and a dividend yield of 1.75%.

Bank of America is one of the big financial and bank stocks.  BoA recently completed a deal to buy Countrywide Financial, the top, but troubled, mortgage lender.  It has a market cap of $186.6B, a PE ratio of 12.74, and a dividend yield of 6.09%.

Chevron is an oil, chemical, mining, and energy company.  It has a market cap of $166.4B, a PE ratio of 8.99, and a dividend yield of 2.94%.

All of these companies are large, and all have global operations.  Honeywell is the smallest of the four and also has the lowest dividend yield.  So this change will increase the market cap and the dividend yield of the Dow index.  It will lower the index PE ratio.  It will also shift the sector balance of the Dow, since some tobacco, manufacturing, and technology are being dropped.  More financials and oil are coming in.  The financials and oil seem to be more cyclical than the others, and especially now with the credit problems and high oil prices this shifts the Dow’s position in the current market environment.

Another thing this changes is the risk faced by Dow components.  Altria has recently dealt with lawsuits and government regulations, but seems to be through most of it.  Large portions of the lawsuits against tobacco were resolved in recent years, and global tobacco sales and prices have been strong.  On the other hand, financials and oil companies have been under scrutiny for their practices and pricing.  Bank of America will have it’s mortgage and credit card operations watched and possibly regulated.  Chevron will be watching for regulations aimed at high profits from high oil and gas prices.  On the positive side Chevron will be profiting from those high prices.  And BoA will hopefully come through the credit problems and maintain both it’s high dividend and it’s credit rating.

So, what is important here?  The Dow is a popular index, and popular indexes highlight the market’s performance.  But you can see that this highlights part of the market, and next week that part will be different than this week.  I don’t have any investments based on the Dow, but I do have investments based on other indexes.  The highlight of this news to me is make sure you understand what your index is supposed to do.