Choosing Investments is Like Choosing a Pizza
April 20, 2016When financial planners talk about how to invest your money in the market, we often discuss dividing it up among stocks, bonds and cash (also known as your asset allocation). But then when you actually go to make your investment choices, there’s a chance that not one of the options will have the word “stock” or “cash” in it. One of the most confusing things about investing and financial instruments is the fact that there are so many words that mean the same thing. For example: stock, equity, share, capital, blue chip, mid cap, small cap, large cap …they all generally refer to the same thing: ownership in a public company. Likewise, bonds, fixed income, municipals, T-bills, etc. are all referring to similar debt instruments used by companies and governments to finance operations and projects.
I often think that if more people understood that many of the financial terms we hear refer to the same thing that there would be a lot less stress around investing and everyone would feel more comfortable taking advantage of the growth that investing in the markets can offer. So I thought I’d try instead to describe a metaphor that is near and dear to my heart to try to make it easier to understand the different options out there: pizza. When it comes to pizza, there are four main options for how to get a delicious pie onto your plate (on a sliding scale of cost and effort) similar to the options available for investing for long-term goals:
- Make your own from scratch
- Buy pre-made frozen
- Pay someone to deliver it to you, ready to go
- Have it served to you at a restaurant
Each level requires a different amount of money and effort. Choosing how to invest money in the market is similar. Here’s how it compares:
1. Make your own from scratch. Making your own pizza requires skill, knowledge and practice, but once you know what you’re doing, it’s the least expensive and can be the most delicious. My husband has mastered the art of homemade pizza, starting with dough he makes from scratch, but it took a couple of years and LOTS of practice (and worthless pizza) to get it right.
To me, this is similar to researching individual stocks and mutual funds and buying them through a discount broker. You have to know what you’re doing or you can end up with nothing, but people who know what criteria to look for and how not to take too much risk can really grow their money. For investors looking to learn the art of DIY investing, start with money you can afford to lose and start reading. The book “Grande Expectations,” was what brought home to me how the stock market really works and why buying the hottest name stock or fund isn’t necessarily the best investing strategy.
2. Buy pre-made frozen. Putting a frozen pizza in the oven and knowing exactly when it’s done (and exactly how long to let it cool so that it doesn’t burn the roof of your mouth) requires some skill and it’s still a pretty cheap way to go. The investing equivalent would be using index funds or ETFs to create your own investment mix. This requires that you understand how to create an asset allocation that is appropriate for your timeline and risk tolerance, but with a little understanding of what the different indices are, it’s pretty simple to put together a decent mix. The trick is knowing when to make changes as time progresses and also knowing when NOT to make changes (for example, not selling when the market tanks and re-balancing even when the market is hot).
3. Pay someone to deliver it to you, ready to go. Minimal effort but a little bit more money. You have to pay to get it to your door, after all.
The investing equivalent would be target date funds. You don’t have to do anything but pick one and let it ride. No pizza or investing knowledge required, you just pick the one that fits you the best (for target date funds, that’s the year that you expect to need the money such as your retirement age).
4. Have it served to you at a restaurant. Paying for someone to make your pizza and serve it to you piping hot along with beverages is similar to paying a financial advisor to manage your investments for you. You can describe what flavors you like and your server will help you pick the best pizza combo.
It’s the same thing with your financial advisor. She’ll listen to your goals and risk tolerance and then suggest an investment mix that is appropriate for you. Along with that, your financial advisor should look at how your investments fit into your overall goals and make suggestions for any changes to support those goals, much like a server at a restaurant might suggest the best beer pairing or salad to start. This is definitely the most expensive option, but if you want a little more hand-holding with your investing, it’s worth it.
In my experience, most people are delivery-types (target date funds will do the trick) but because they’ve heard you should diversify and not just hold one thing, they often think that means they need to choose more than one fund. It’s important to know that a target date fund is already diversified. Just like a pizza is the perfect assembly of crust, sauce, cheese and toppings, a target date fund can be broken down into the perfect mix of large cap, mid cap, small cap, international, fixed income, money market and sometimes even commodities – the fancy way of saying stock, bond and cash funds. But instead of you having to figure out how much of each to select, that decision is made by experts who specialize in asset allocation – just like the pizza chef knows the best mix of ingredients according to the type of pizza you ordered. Now, who’s hungry for pizza?