Friday, September 25, 2009

Asset Allocation: Part 4 – Risk Tolerance

In Part 2 of this asset allocation series I assumed 25% allocations for each asset class in the example portfolio. Selecting the target asset allocations for your portfolio is not a science – despite the “Risk Tolerance” surveys and formulae offered by many financial planners.

There are some basic concepts you should consider when setting asset allocations:

1. The closer you are to retiring the greater the allocation of your total assets to “safer” asset classes and the lower your allocation to “risky/aggressive” asset classes.

2. Money you expect to need within the next five to ten years (depending on which financial planner you listen to) should be held in cash or cash equivalents; money market funds, Bank CD’s (certificates of deposit), or laddered bonds (not bond funds).

3. A large enough allocation must be made to more aggressive asset classes to keep up with inflation because the average woman who retires at the age of 62 will live another 25 years; the average man another 20. Many will live 30 years after retiring and some will live 40. In 30 years even moderate inflation rates can be devastating to the value of your portfolio.

4. Emergency funds must be held in cash or cash equivalents that can be withdrawn quickly without penalties.

5. If allocations are too lopsided in favor of any asset class rebalancing will have little value.

6. You have to sleep at night. If your investments keep you from sleeping change your allocations to favor safer asset classes.

Planners advocate allocation plans that vary all over the place. I’ve read advice for twenty-somethings to be 100% in growth stocks. At the other extreme, I’ve seen advice that everyone, regardless of age, should be 50% in stocks and 50% in bonds.

Here’s my advice:
1. Have some money in cash, have some money in bonds, have some in stocks, have some in gold, and have some in real estate. Each of these asset classes should be at least 10% of your portfolio value and none should exceed 70%.

2. Your emergency fund is not part of your portfolio. It should be 100% cash and not count as the cash portion of your portfolio.

3. If you are within five years of retiring you should start building up the cash portion of your portfolio so that on the day you retire you will have enough cash in your portfolio to cover your expenses for five years – after subtracting expenses you plan to pay with money from Social Security, a fixed pension, or income from an annuity.

4. Within these constraints, design your portfolio to grow to meet or beat inflation not counting the new money you will invest – but with asset allocations that let you sleep at night.

5. Rebalance your portfolio annually – perhaps around your birthday.

6. Reconsider your asset allocations annually. You’re getting older and you may be getting wiser.

Risk tolerance and setting asset allocations is more art than science regardless of the research and the formulae used by financial planners.

Links to other Topics in the Special Report: Asset Allocation

Friday, September 18, 2009

Asset Allocation: Part 3 - Rebalancing

Having a mix of uncorrelated asset classes in your portfolio tends to protect the portfolio from downturns and to limit the gain from upturns in any asset class. Asset rebalancing is a powerful tool to improve your overall results.

Most financial planners recommend rebalancing annually. Others have data showing portfolio gains are higher when it is done less frequently – every two or three years. Yet another recommendation I’ve seen is to set gain or loss targets and rebalance only when one of the targets is attained.

Whatever rebalancing frequency is used, the act of rebalancing is the same. You choose an allocation percentage in advance for each asset class and, when you rebalance, you sell enough of the class that is above target to bring its actual portfolio percentage back to its target.

On the other side of the transaction, you buy enough of the classes that are below target to bring their portfolio percentages back up to target. For a portfolio in which you’re still investing new money, you can rebalance by buying only the asset classes that are below target.

When you periodically rebalance, you systematically sell investments that are up in value while their prices are high; and you systematically buy more of the classes that have declined in value while their prices are low.

The old truism is that the essence of investing is to buy low and sell high. Unfortunately, most people don’t have the self-discipline to execute that advice. Plus, nobody knows when the price has stopped going up until it goes back down. Nor do they know when the price is hits bottom until it goes back up. Consequently, most people invest by emotion and often buy high and sell low.

Asset rebalancing makes the “buy low, sell high” discipline much easier to live; you just move the money from one asset class already in your portfolio to others using pre-set rules for the transaction timing and amounts.

I’ve seen data that indicate regular rebalancing over many years increases the final portfolio value by 30% to 100%.

Asset rebalancing improves your investing results in a portfolio of uncorrelated asset classes.

Links to other Topics in the Special Report: Asset Allocation

Friday, September 11, 2009

Special Report: Asset Allocation

Other Asset Allocation Topics:

Asset Allocation: Part 1 - Introduction
Asset Allocation: Part 2 - Asset Classes
Asset Allocation: Part 3 - Rebalancing
Asset Allocation: Part 4 - Risk Tolerance

Asset Allocation: Part 2 – Asset Classes

Asset Allocation is kind of like putting your eggs in several baskets and giving the baskets to people who take different routes to Granny’s house. The trick is to choose high quality baskets and to choose routes so the Wolf can’t intercept more than one basket.

The value of your investment portfolio should be divided among several different asset classes. Examples of asset classes are cash (bank or money market accounts), U.S common stocks, U.S. preferred stocks, U.S. corporate bonds, U.S. government bonds, commodities, international stocks, international bonds, and real estate. This is an incomplete list but covers the classes most commonly considered and bought.

Asset class subcategories include large cap stocks (big public companies), small cap stocks (relatively small public companies), growth company stocks, value stocks, and dividend paying stocks. Subcategories frequently overlap with a single company falling into more than one category.

Asset allocation is not just diversification. Diversification refers to owning multiple stocks or bonds with the objective being to protect your wealth in the event one of the companies you are invested in becomes worthless. To be sure, asset allocation also provides the protection of diversification. The difference is that in asset allocation you intentionally invest in asset classes that tend to increase or decrease in value independently from one another.

For example, usually as the price of stocks go up the price of bonds go down. The same is true of cash and commodities – when one goes up the other normally goes down.

Nowadays, there are ways to invest in commodities and real estate through stocks, ETF’s and mutual funds so even a modest portfolio, like mine, can take advantage of asset allocation using a variety of asset classes. A sample portfolio might consist of shares in an Extended Market Mutual Fund, a Total Market Bond Fund, a REIT (Real Estate Investment Trust) Fund, and a Precious Metals Mutual Fund. The allocation percentages might be set to 25% for each class.

The sample portfolio might behave in the following ways under the specified market conditions:

1. Conditions - slow economic growth with low inflation:

a. Extended Market Mutual Fund increases slowly
b. Total Market Bond Fund is stable and paying consistent dividends
c. REIT Funds increase slowly
d. Precious Metals Mutual Fund declines slowly

2. Conditions – slow economic growth with high inflation:

a. Extended Market Mutual Fund is stable
b. Total Market Bond Fund declines
c. REIT Funds increases rapidly
d. Precious Metals Mutual Fund increases rapidly

3. Conditions – recession with low inflation

a. Extended Market Mutual Fund declines
b. Total Market Bond Fund increases
c. REIT Funds decline
d. Precious Metals Mutual Fund is stable

Ideally, one or more asset classes will go up regardless of the market conditions. By itself, this kind of an asset mix will tend to preserve the value of the portfolio protecting it from big declines and also preventing big increases. A powerful tool to improve this result is “rebalancing”.

The next post will explain portfolio rebalancing.

Links to other Topics in the Special Report: Asset Allocation

Friday, September 4, 2009

Asset Allocation: Part 1 - Introduction

Financial Planners seem to talk about asset allocation all the time. They recommend percentage allocations to various investments (usually different mutual funds) based on some assessment of your “risk tolerance”.

Usually you end up buying some shares in a “large cap growth” fund, a “large cap value” fund, a “small cap” fund, an “international” fund, and a “bond” fund. The percentages vary with your age and your “risk tolerance”.

Asset Allocation is kind of like parceling your eggs out into three to six different baskets, giving each basket to a different person and instructing each person to take a different route to Granny’s house. Most of the baskets will get to Granny and miraculously, each basket that arrives at Granny’s house will have more eggs at the end than it had at the beginning of the trip.

Like most people, my first exposure to asset allocation was sitting down with a Financial Planner who was armed with a “Risk Tolerance Assessment Survey” and a “Financial Goals Survey”. I filled out the surveys and several days later a “Personalized Financial Plan” was delivered to my doorstep filled with monthly saving and investing targets, asset allocation percentages for each of the recommended mutual funds, and of course, Life Insurance.

It was a decent plan and I promptly filed it away where it would not likely see daylight again for several years. My budget couldn’t be squeezed enough to do half of the Personalized Financial Plan and the guy was obviously trying to sell life insurance so I did nothing. That was a mistake.

If I had done even a little of the investing portion of the plan I would be much wealthier today - some thirty years later. But I was young, foolish, over-confident, indestructible, ambitious, and over-whelmed by the whole “asset allocation” thing – plus suffering from sticker shock.

I can’t help you with the young, foolish, over-confident, indestructible, and ambitious parts. But I can help with the “over-whelmed” part and the sticker shock part.

The Asset Allocation trick is to choose high quality baskets and to select the various routes to Granny’s house so the Wolf can’t intercept more than one of them.

In Part 2, I’ll discuss selecting the routes – that is – selecting different types of investments that are poorly or even negatively correlated.

Links to other Topics in the Special Report: Asset Allocation