Wednesday, December 15, 2010

Investment Lesson #6 - Asset Allocation

Asset allocation is simply how much of your money you split into stock, bonds, real estate and other investments. You've probably heard the old saying, "Don't put all your eggs in one basket." In the financial world that usually refers to diversification as a means of reducing risk. However, there's a flip side to this, "Put all your eggs in one basket and--watch that basket." The meaning of this is that someone who concentrates his efforts in one area is more likely to succeed.

So which is best for you? It depends. Let's start by taking a wider view of asset allocation, a much wider view.

In the big picture, everything available to you, both tangible and intangible, are assets. A nice smile, a bicycle, money and time are all examples of assets. The opposite of assets are liabilities, these are things that hold you back. The most obvious example of a liability would be debt, but it could also be a pimple on your face or a lack of time. We all have a mix of assets and liabilities. That nice smile could overpower the pimple on your face and a strong will could overcome a severe handicap. Likewise as you have learned in lesson #2, if you have a long time frame to invest in, it could offset not having much money due to the power of compounded return on investment.

Sometimes an asset could turn into a liability. For example, owning stocks during a bear market or holding long term low yield bonds while interest rates are rising. But what if you owned both stocks and bonds?

Over the long term both stocks and bonds have given investors positive returns. However, they don't always move up and down in value at the same time. In fact there are times when they move in opposite directions. Having a mix of stocks and bonds is known as a low-correlation investment mix and this is generally what financial managers recommend in order to minimize risk.

What is the ideal mix of stocks and bonds and for that matter, which stocks and bonds work best for this method of asset allocation? I would recommend something that closely resembles the "Couch Potato Portfolio" in Paul B. Farrell's book, The Lazy Person's Guide to Investing. Farrell's portfolio is a 50-50 mix of the Vanguard 500 Index Fund (VFINX) and the Vanguard Total Bond Market Index Fund (VBMFX), I substituted the Vanguard Total Stock Market Index Fund for the 500 Index Fund because I wanted to have greater diversification in the stock portion of the portfolio. This asset allocation has served me well during the crash of 2008 when stocks plummeted and the subsequent interest rate cuts by the government to restart the economy boosted the value of bonds. Although the target 50-50 ratio got out of whack at times, I didn't have to exchange shares to rebalance. I simply kept up my regular monthly investments and bought into whichever fund was lower at the time in order to get the mix back to 50-50. The advantages to this are, and I quote from the book:
  • No complicated accounts.
  • No diligent reading of the financial press.
  • No phone calls from brokers with "opportunities."
  • No meetings with investment advisers demonstrating their constant supervision of accounts.
  • Very simple tax returns.
So that's it. This is all you need to know about investing and asset allocation. If you skipped all the other lessons and heed the advice of these last few paragraphs, you'll probably be a successful investor practicing not only the advice of, "Don't put all your eggs in one basket," but also allocating as little of that valuable asset, time, to managing your investments.

Of course you could change the mix depending on your age and your risk tolerance. Generally, younger people have a longer investment horizon (the horizon generally referring to retirement) and want their investment to grow in value while older folks usually prefer a steady income stream from their investments. Jack Bogle, the founder of The Vanguard Group, suggests holding a mix of stock and bond funds equal to your age--in bonds. In other words a 20 year old would own 20% bonds and 80% stocks while an 80 year old would own 80% bonds and 20% stocks. The 50-50 split worked fine for me but then again I'm in my 50's.

Now let's put all our eggs in one basket.

If you take a look at the richest people, the very top few, you'll find that most of these people are wealthy because of one thing, one business with one main product or service, they are specialists. Each empire might be made of computer software or manufacturing or communications or real estate or even royalty but most every ultra-rich person has made their money in a single field. Unless they have inherited their wealth and are living off of a trust fund, these very wealthy are pretty much fully invested in their one thing.

I have seen first hand how a couple of very wealthy individuals work, Steve Jobs and Jeffrey Katzenberg. I can't say that I've gotten very close to either of them or that I'm much of an expert on their lives and working methods. What I can tell you is that these two remarkable men work much harder and are more focused on their work than I or anyone else that I have met.

I can't give much advice into what single investment is going to work best for you. Whatever you do choose, you had better know it well.

Though I usually prefer to keep a mix of stocks bonds and real estate right now most of my money is in real estate. As I write these words real estate prices are down which make it a good buying opportunity. I can't say if the housing market hit bottom yet but the prices of a condo on the beach have come down to a point where we don't have to look to Mexico for something that we can afford. We found something just a few miles away so we're buying it. I made it a point in the real estate investment lesson that it isn't an investment until you rent it or sell it, we'll be renting out this one. In a few years when the housing market hopefully recovers we plan to sell our house and move into the beach condo or perhaps sell the condo if we decide we're not cut out for beach living. In order to make this deal I had to cash out our non-retirement stock and bond funds. I didn't take out a mortgage this time. Even with today's low interest rates, the last thing I wanted to do was to get myself into debt.

Am I crazy to do this? Like the saying goes, "hindsight is 20/20," so ask me in a few years. Interest rates have been at historic lows for the past couple of years and at some point it will most likely start moving up. This makes bonds unattractive and holding long term bonds very risky. Stocks will most likely continue their long term upward trend but like always, it will be a bumpy ride. I recently traded the Vanguard Total Bond Market Index Fund that I held in my Individual Retirement Account for the Total Stock Market Index Fund.

Working out your own asset allocation strategy is highly personal. It really depends on your tolerance for risk, your perception of investment conditions, the amount of time you can devote to studying your investments and it is also dependent on your tax situation. Earlier I mentioned that I held the bond funds in my retirement accounts. Assuming that I will be holding onto my IRA's for several years before making withdrawals it might seem at first that stock funds would be a better choice. It isn't, at least not if you are holding a mix of stock and bond funds. The reason is because of tax efficiency. Bonds generate income and that income is taxable. Most of the gains in stocks and real estate come from growth, also known as capital gains. Those type of gains aren't taxed until the asset is sold.

Although you can get by fine and be a successful investor with a very simple asset plan, the study of asset allocation, also known as modern portfolio theory, can be very complicated.

From Wikipedia:
Modern portfolio theory (MPT) is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics.
I first learned about about "behavioral economics" just a few days ago. In a way, it neatly sums up these investment lessons.

Again, from Wikipedia:

Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market prices, returns and the resource allocation. The fields are primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory.

Behavioral analysts are not only concerned with the effects of market decisions but also with public choice, which describes another source of economic decisions with related biases towards promoting self-interest.

Investing has as much to do with our psyche as it does with interest rates and return on investment. Before you spend another dollar, consider your choices. Do you really need to buy that new toy or would it be better to pay down your debt? Can you picture yourself free to choose how you spend your time or are you going to be stuck in a job where you don't have this choice.

Let's end these investment lessons with one final quote. This is a definition of money that has profoundly changed the way that I think about my own personal finances:
"Money is something we choose to trade our life energy for....This definition of money gives us significant information. Our life energy is more real in our actual experience than money. You can even say money equals our life energy. So, while money has no intrinsic reality, our life energy does--at least to us. It's tangible and it's finite. Life energy is all we have. It is precious because it is limited and irretrievable and because our choices about how we use it express the meaning and purpose of our time here on earth."

--Your Money or Your Life,
Transforming Your Relationship with Money
and Achieving Financial Independence

by Joe Dominguez and Vicki Robin



1 comments:

dfort said...

I recently read this post from The Animation Guild Blog that nicely sums up my investment lessons.

Note that there are several references to 401k plans in this post, something that I have not covered in my lessons. Basically, they are company sponsored retirement plans that are somewhat similar to individual retirement accounts (IRA's).

-----------------------------------

The Simplicity of Accumulation

Regarding (yet again) how an animation employee -- or most anybody else -- should save:

Take 10% of whatever you make and tuck it into savings/investments. Pay yourself first. Pretend that slice of the paycheck isn't there and live on what's left.

And here's what you should put the money into (and I think the investment reporter writing this is dead on) ...

... Mutual funds reporters lead a secret investing life. By day we write 'Six Funds to Buy NOW!' We seem to delight in dangerous sectors like technology. We appear fascinated with one-week returns. By night, however, we invest in sensible index funds. ....

After months of interviewing managers and studying statistics and strategies, I made only one move in my own retirement portfolio--into my fund family's more diversified index fund. The fund reporters I knew came secretly to favor low-cost index funds. ...

Unfortunately, rational, pro-index-fund stories don't sell magazines, cause hits on Websites, or boost Nielsen ratings. ...


The above was published in 1999, at the peak of the tech fund craze, a time when Animation Guild members were stopping me on the street to exult in their huge runups in the TAG 401(k) Plan's tech stock index fund. (What can I say? It was a simpler, more optimistic time. Of late, nobody has bragged about the huge profits they're making. Draw your own conclusions.)

Here's the distilled wisdom: Keep your investing costs as low as possible. Be broadly diversified with both stocks and bonds. Add more bonds to the mix as you get older.

That's it in a nutshell. (And the shell is simple, is it not?) But here are the two rules that are more difficult, and make the points above tougher to execute.

1) Don't chase returns in the latest "hot sector" (even though all your best buds are doing it.)

2) Don't bail out of your allocation of stocks and bonds when it's tanking. (And at some point it will tank.)

I encounter people at 401(k) meetings who tell me they have no interest in investing. I (sort of) understand their position, but let's get realistic here. This is your money we're talking about. And if you haven't got the gumption to read a couple of books on where to put the moolah and take a few hours to educate yourself, you're as foolish as somebody who declares they have zero concern about their health. ("I'm going to go right on drinking six packs of Colt .45 and gnoshing on Big Macs. I like it!")

I'm not advocating becoming some kind of obsessive expert on stock market trends, just arming yourself with rudimentary facts. If you do no more than putting your extra cash in a target retirement fund or asset allocation fund, you'll be ahead of ninety percent of the population.

Posted by Steve Hulett