Many investors believe a diversified portfolio is holding 20, 30, or more individual stocks. While this strategy gives you protection against idiosyncratic risk from an individual stock, it does not give sufficient protection against many other investing risks. Variables such as the business cycle, monetary & fiscal policy, international relations (trade) and the never-ending expansion of laws and regulations must be considered.
An Investment Portfolio Should Account for the Following Economic Variables
This represents the part of the business cycle in which the output of goods and services is increasing in an economy. It is during this time that companies are experiencing sales and profit growth, unemployment is declining, and new investment in buildings and factories is robust. The growth leads to, all else equal, investors willing to pay more for shares of stock in companies whose sales and profits are increasing.
Investments to consider: Equities
While there are numerous catalysts for a recession, all are defined as the part of the business cycle in which there is a general decline in economic activity. This decline results in slower sales growth for many companies and consequently smaller profit growth, or even declining profits. Typically, during recessions, the Federal Reserve will lower interest rates to stimulate growth. A decline in interest rates increases the value of bonds. As an example, if a bond is paying 2% for the next 30 years and interest rates are lowered to 1%, the price will increase for the 2% bond as its higher yield now has more economic value to the holder.
Investments to consider: Long Term Bonds
Declining Value of a Dollar
Inflation reduces the buying power of a unit of currency. You may have experienced this in your day to day life when your Starbucks coffee or the new Ford F150 you wanted costs more than it used to. Inflation is the result of more money chasing the same amount of goods and services. To give an example of how this plays out in the real world, imagine there are two individuals, both with cash in their pocket, looking to buy the last big screen TV. Since only one can purchase it, they are effectively competing against each other. The store, knowing this, will increase the price until only one can afford to pay. The more cash these individuals have in their pocket, the more they will be willing to pay; leading to a higher price for the TV.
Investments to consider: Tangible Assets
Increasing Value of a Dollar
Deflation is the opposite of inflation; a unit of currency purchases more goods and services than it used to. Continuing with our example from above, imagine now the store has two TVs left that they need to sell. Now the seller has to offer a lower price in order to induce both individuals to buy. As a result, the price of the TV will be lower.
Investments to consider: Cash