In order to give you perspective, I want to show you how stocks, bonds, and cash have performed historically. I also want to point out how crucial it is to have the proper asset allocation for your investment portfolio. In this chapter, I will explain all about asset allocation and asset classes including equity, fixed income securities and cash equivalents, the volatility of them all, and how to determine your overall risk tolerance.
Before I begin, let me highlight an interesting study by Joseph Davis, PhD, and Daniel Piquet of Vanguard, an investment company with more than $3 trillion in global assets under management. In 2011, Davis and Piquet wrote a white paper titled “Recessions and Balanced Portfolio Returns.” According to their study, since 1926, a diversified investor’s overall return didn’t dramatically change whether the economic environment was expanding or contracting. As long as the investor had a mix of 50 percent bonds and 50 percent stock, they averaged a return of around 5 percent per year, on a net return basis of factoring in inflation. Of course, past returns are no guarantees for future performance, but it does give an investor a sense of what is potentially reasonable to assume as a rate of return if they are equally diversified in equities and bonds. While past performance is not a guarantee of future results, smart investors in today’s modern world might take Mark Twain’s well known quote to heart: “History doesn’t repeat itself but it often rhymes.”
Let’s discuss some basics about stocks and bonds because equities (a.k.a. stocks) and fixed income (a.k.a. bonds) should make up the core of your investment portfolio. They are what drive the “financial engine” of your wealth creation automobile and help you achieve your financial goals.
By purchasing shares of stock you have the opportunity to own a piece of that company. You share in its profits and its losses. You need to understand that you’re not just investing in something to make money immediately—there is a company behind what you’re investing in, and you’ve got to understand what makes it run and how it plans to grow, who is its competition, and what the risks are in making the investment. The biggest risk is that you can lose all of your money when investing in a company’s stock.
The important thing to know about buying stocks is that you should be investing in them for the long-term, because the potential for growth occurs over years, not days or months. It is not feasible to accurately predict what direction the stock market will go in the short term: Some inexperienced investors pay more attention to what the media is saying about the markets on a particular day than to what is appropriate for them long term. This gets back to what we discussed earlier, if you stick to your plan, you can shut out the noise. You should have a strategy in place, and not one that is driven by what the market did in the past three hours, or what the pundits say will happen tomorrow. It is true that with the world’s interconnectedness, bad news travels quickly and the fear from the bad news creates violent negative short-term momentum. For this reason, the portion of your portfolio that is allocated in stocks should be of high quality companies in different sectors and asset classes that have growth and dividend potential. Warren Buffett once said, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
A bond is basically a loan where you are the lender. The organization that sells a bond is known as the issuer, which can be a company or government. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (you, the investor). Bonds are fixed income instruments. They’re supposed to be conservative and are the part of your portfolio intended to be stable although, of course, there will be times when that is not the case. When interest rates go up, the value of bonds will go down. When interest rates go down, the value of bonds will go up. A bond’s “duration,” measured in years, will help provide a general idea of how the bond will perform based on a changing interest rate environment. It is not exact, but for every percentage point that interest rates rise (or fall), the bond’s value will decline (or increase) by its duration. The shorter the duration, the less sensitive that bond is to changing interest rates. Here is an example of how duration works: If rates fall by one percentage point, the Vanguard Total Bond Market index, which currently has a duration of 5.7 percent, would rise by 5.7 percent. Since the fund also pays investors bond interest of 2.1 percent per year, it would post a total return of 7.8 percent. (2.1 percent + 5.7 percent = 7.8 percent). Conversely, if rates were to rise by one percentage point, the fund would lose 3.6 percent (2.1 percent – 5.7 percent = –3.6 percent).
Cash equivalents are assets that can be converted to cash quickly and easily. These securities have a low-risk, low-return profile. They are short-term instruments, have high credit quality (which means there is little risk of default), and are highly liquid. Cash equivalents include U.S. Government Treasury Bills, short-term government bonds, bank certificates of deposit, bank savings accounts, and other money market instruments. Remember, don’t expect much return from these types of investments, you are paying for security and liquidity.
Recently, there has been a growing interest in alternative assets. Most alternative assets include commodities and other hedging strategies such as options (puts and calls on stocks). A good way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a possible negative event.
When used appropriately, investments in alternative assets can help to minimize risk in an investment portfolio. Unfortunately, due to liquidity issues, when used inappropriately, they could be seen as financial weapons of mass destruction. We will not discuss alternative strategies at great length in this book since my focus is on imparting a sound long-term strategy to help you build the appropriate money mindset. However, if you want to learn more about “alts,” there are many books on the subject that can offer some appropriate ways of utilizing such instruments.
Now that you have a bit more knowledge about stocks (equities), bonds (fixed income), and cash equivalents, it is time to think about allocating the assets in your portfolio. But, you’re probably wondering, what exactly is asset allocation? And just what is the appropriate allocation for you? How do you determine it? How much equity and bonds should you own? How much cash or cash equivalents should you hold?
First, asset allocation involves dividing your investment portfolio among your stocks, bonds, cash, and perhaps alternative assets. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.
By including asset categories with investment returns that move up and down under different market conditions within a portfolio, you have the potential to protect against significant losses. The correct asset allocation is the one that helps you to meet your financial goals. This is because you’re able to maintain it during most all market conditions and you understand and take into consideration your time horizon. If you are three to five years from retirement with a moderate tolerance for risk, you might split your money evenly between stocks and bonds. But if you are a more conservative investor, you might put only 30 percent in stocks. If you are younger and have a longer time horizon, you might consider anywhere from 60 to 80 percent in stocks for your asset allocation.
Historically, the returns of the four major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride. If one asset category’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another asset category.1
In 1986, Gary P. Brinson, Randolph Hood, and Gilbert L. Beebower wrote the paper “Determinants of Portfolio Performance” for Financial Analyst Journal. The authors asserted that the asset allocation of a portfolio is the primary determinant of the portfolio’s return, with security selection and market timing playing only minor roles in total performance. Their study examined the quarterly returns of 91 large U.S. pension funds from 1974 to 1983. Their conclusion was that 93.6 percent of the variation of return was a result of the portfolio’s asset allocation.
Overall, your asset allocation is determined by the amount of risk you can tolerate. Completing a risk tolerance questionnaire will help you in your determination.
Here are some sample questions that you might see in a risk tolerance questionnaire….
If your portfolio valued at $50,000 declined in value to $39,000 within one year, what would you likely do?
- Sell all the positions and move the money to safer investments.
- Sell only the losing investments.
- Sell nothing.
- Buy more as the losing investment may represent opportunity
If the above portfolio declined by an additional 10 percent to $35,100 the following year, what would you most likely do?
- Sell all the positions and avoid investments that fluctuate greatly.
- Sell only the losing positions and move the money to safer investments.
- Keep the same positions.
- Purchase additional positions as the investments that declined may represent an opportunity.
There are a number of risk tolerance questionnaires available online for free.
Vanguard has a one that you might find helpful, at www.vanguard.com/assetmix.
If you really take the time to understand your risk tolerance and you allocate your portfolio holdings based on how you answer the questions, then you really don’t have to be so emotionally susceptible to the gyrations of the markets on a day-to-day basis. You will know that you followed a very methodical process to get to those allocations. The questionnaire helps you think about all of this by using an emotional context. So when you are in an environment where the markets are quite volatile, you can feel confident sticking to your strategy. In a calm environment, you will have already thought about your potential actions and reactions in a potentially emotional situation; basically, the risk tolerance questionnaire helps you determine at what point in a market decline your portfolio becomes too volatile for your own personal risk tolerance, risk capacity, and risk perception.
Once you have gone through the risk assessment process, you can rest assured you’re allocated appropriately. I suggest that you revisit the risk tolerance questionnaire regularly to update and keep yourself focused. If your new answers lead you to feel that you need to be a bit more conservative with your investments, then you can adjust your investments with confidence. Remember, the key is to look at the end game and recognize there is almost always going to be volatility in the short term.
The odds of benefiting long term from the capital markets are best when you understand the logic of asset allocation, complete a risk tolerance questionnaire, and then diversify accordingly.
If you follow this process, then during emotional moments you won’t fall prey to a knee-jerk reaction. It is in those moments of great emotion when you can become your own worst enemy. Sometimes, you might need an advisor to hold your hand and help you through those times, and/or you can go back to your plan and make sure that you’re still on target.
Let me tell you a story about why asset allocation is like making salsa.
I heard Craig Israelsen, PhD, a Personal Finance Professor at Brigham Young University, speak about his approach to asset allocation. His explanation is unforgettable. He said that asset allocation is a lot like making salsa. So, for the ingredients you’re going to have tomatoes, onions, cilantro, lime, spices, and some jalapeno peppers. Each ingredient is unique and different. Yet, when you have the right proportions and you blend them together as a group, it takes on a wonderful new flavor. If you taste the salsa, it’s difficult to discern the tomato, the lime, or the jalapeno pepper. When mixing the ingredients, they become entirely new. The jalapeno pepper could be the equivalent of alternative assets in your portfolio. You don’t want too much jalapeno pepper because you won’t be able to taste the other flavors and it could set your mouth on fire. That’s the beauty of a good salsa. It’s simple, yet distinguishable and flavorful. But, with too much of any one ingredient, it really can take away from the balance of the perfect salsa that it could be. If it’s too hot, you’re not going to want to taste it again. Investors want to not have too much jalapeno pepper in their portfolio and have a nice mix of tomatoes, onions, and other ingredients.
Okay, enough about salsa. Let’s go back to the basics of financial success: You must have a strong offensive strategy that will make you money for the long term. You can use your more defensive strategies where you’re trying very hard to preserve your gains. A strong offense wins games, but a strong defense wins championships.
What it comes down to is that the right asset allocation will help your plan be successful. If the plan is too aggressive, all it takes is one major market correction and you will probably no longer buy into the concept of investing in equities (stocks). If you are not aggressive enough, your portfolio won’t benefit from compound interest as it normally would, and the portfolio is just not going to grow as it needs to grow in order to help you reach your goals.
It is really important to have balance in the portfolio. With bonds, you have those built-in shock absorbers that help your defensive strategy and give you a much smoother ride. Even though we all know that there are going to be potholes in the road, by having a good mix of stocks and bonds in your overall portfolio mix, the ride will still be tolerable.
Rebalancing is really a forced way to incorporate the “buy low, sell high” mantra. For example, if you had $100,000 and 70 percent of that money was allocated to stocks, 20 percent in bonds; and 10 percent in cash, it might be that the next year that $100,000 grows to $150,000 but the growth was from the bonds. Since the bonds appreciated in value, that takes the asset allocation that you had determined based on the risk tolerance questionnaire, and throws the balance of investments out of whack (the problem would be that now your asset allocation is out of balance). Being out of balance could mean that if the markets are going up, you could miss out on the upside; if the markets are down, you may lose more than you thought you could. So it is important to always make sure that you’re rebalancing back to your risk level.
In the previous example, rebalancing forces you to sell those bonds at a profit, and then take the profits and reinvest them back into the asset class that underperformed. So, in essence, you’re forcing yourself to buy low.
Investors should consider rebalancing annually regardless of what happens in their lives. If you have a life-altering event such as a death, a promotion, or job loss, you would be wise to complete a new risk tolerance questionnaire. If your life has shifted and your situation is much different than it was before, it might mean you are in a position to take on more risk (or less). For example, if you are retiring, you may need to take on less risk. So, by redoing the risk tolerance questionnaire, you essentially reassess the appropriate allocation based on your life after that major event.
It’s actually quite simple to rebalance. Many times, 401(k)s allow you to rebalance your portfolio quarterly or annually. If you work with a financial advisor, he or she may already be rebalancing for you. So, it can be as easy as checking a box and saying, “Okay, rebalance my portfolio annually or quarterly.” That way it’s automated and you know that your portfolio will never deviate too much from where it needs to align with your long-term goals.
But let’s not forget about volatility and how it can be measured. Of course, the higher the volatility, the riskier the investment. Beta is one of many measurement tools that helps evaluate past volatility or the systematic risk of an investment. It does this by measuring the volatility of a portfolio relative to the S&P 500, which is one of the most commonly followed equity indices (many consider it one of the best representations of the U.S. stock market and a bellwether for the U.S. economy). So, for measuring beta, or volatility, the S&P 500 in this case is the benchmark, which always carries a beta of 1. Most financial professionals consider the S&P 500 to be an aggressive investment. For example, in 2008 (which was during the great banking and mortgage crisis) the S&P 500 lost approximately 37 percent of its value in just one calendar year. If investors decide that they do not want to potentially lose that much of their value in one calendar year, I might suggest then that the beta of their portfolio should be less than 1. If someone had a beta of .8, it would mean that they carried 80 percent of the risk of the S&P 500. Another way of saying this is that an investor who carried a beta of .8 had 20 percent less risk than the S&P 500. Whereas, if someone has a beta of 1.2, it means that they have 20 percent more volatility, which means they will go up 20 percent more, but they’ll go down 20 percent more than the stock market as measured by the S&P 500 index.
More times than I can count, investors have told me that they consider themselves to be conservative investors. With a response like that, I immediately think of a beta that’s less than 1, but sometimes as I’m calculating an investor’s beta, it turns out that their beta is greater than 1. Unfortunately, there’s a disconnect between what they’re telling me (conservative investor) and how their investments are allocated (aggressive investor). Make sure that, if you are conservative, your investments are allocated accordingly. This is one of the many reasons to use a risk-tolerance questionnaire as a self-assessment and clarity tool.
How do you reduce market risk in your portfolio? One of the best ways to lower the beta of a portfolio is by adding cash and bonds.
My father taught me that we diversify not to make more, but to protect what we have already made.
Sometimes a client might say to me, “I know someone whose investment portfolio earned 30 percent last year. Why am I not getting that kind of return?” My respectful response is usually, “Well, we don’t know how they are investing, nor do we know how much risk they are exposed to in order to capture that type of return. We know that you’re investing based on your overall plan, which we have calculated and have, in essence, solved for how much you need to be contributing and at what type of return you should be earning with the lowest amount of risk possible.” The goal is to maximize your risk-adjusted return. At this point, you might be thinking: “That beta thing makes sense; I should know how much risk I am currently exposed to.” Great news: You can go to www.morningstar.com and type in the ticker symbol of almost all publicly traded securities. Morningstar has already done the calculation for you and will tell you what the beta is for that specific investment. This helps you with each individual investment in your portfolio, but won’t give you your overall beta level, which is where a financial planner often comes into play.
Warren Buffett, one of the most respected and publicly known investors, wisely said, “Never test the depth of the river with both feet.” Apply this metaphor to the way you think about your investments and how you build your portfolio. It is just too risky to test the level of risk in your portfolio by trial and error.
I often tell my clients that it is easy to make money during a bull market—a rising tide lifts all boats. The art of wealth management is attempting to minimize losses in the down years. The deeper the hole, the more it will take to recover. This is one reason to consider the benefits of constructing a low volatility portfolio. Instead of embracing investments that are prone to large swings up and down due to various economic and market factors, it might be better to embrace investments that are less prone to wild up and down swings. The goal here would be to create steady growth via market gains and the magic of compounding interest.
Many people may do the mental math that if their investment declines 50 percent, they need only to make 50 percent to get back to even. Unfortunately, that is not how compound interest works. In reality, the investor would have to see a 100 percent gain to fully recover from his or her loss. Here’s an example: Imagine you invested $100,000, then subsequently that $100,000 declined by 50 percent and was then valued at only $50,000. In order to recover the original investment, the investment will now need to appreciate 100 percent to get back to $100,000. For this reason, there needs to be great mindfulness of how quickly things can decline in the current environment.
|If You Lose||Gain Required to Break Even|
Now that you have determined your asset allocation, how those various securities or asset classes have performed historically, and how much you should be putting away on a monthly basis, then you should consider dollar cost averaging every month. Dollar cost averaging is a strategy for buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. As a result, more shares are purchased when prices are low, and fewer shares are bought when prices are high. So, dollar cost averaging allows you to minimize the effect of timing the market (trying to time the market is something I typically advise against). When the markets are down and you’re buying, you’re accumulating more shares. You get a better average share cost when buying at the highs, and you acquire more shares when buying at the lows. If a client says, “I’ve got $2 million; I want you to manage it. It is, right now, all in cash.” I might respond, “Well let’s put this $2 million to work in a diversified investment portfolio, but let’s stream in the cash over six months, not all at once.” The first month we put one-sixth of the money to work in this allocation, the second month we put the second tranche of the sixth in that same allocation. Then we put the dollars to work over six months, so we’re dollar cost averaging in; we’re getting the advantages of both the highs and the lows and we are thus more safely entering into the market.
Let’s assume that you followed your plan, contributed what was needed over many years, earned the appropriate return, plus allowed the plan time to grow to a point where you are able to retire. Congratulations, you now have enough money working for you that you can downshift into retirement. Now what? What is the best way to transition from a saver to spender? How do you begin to live off your investments?
One solid source of retirement income for many individuals is a systematic withdrawal program from an investment portfolio. A systematic withdrawal program allows you to receive a specified amount of money each month. These programs also allow you to continue participating in the potential rewards of your investments while receiving monthly income.
People understand that they need to take income from their investments. Sometimes they may think they only want to take out interest. In an ideal world that would be just fine, but every month the value of their net worth is going to be changing. If you’re investing in equities that are not dividend producing, the upside potential is growth. It’s a good idea to determine a percentage that is realistic to withdraw and then systematically take out the money on which you need to live. Some years, you might be building a surplus, and some years you might be creating a deficit, but on average you would just be taking out enough to comfortably live. The goal is to keep your principle capital at work. In times of difficulty, you may decide to temporarily spend less. As Ben Franklin often said: “A penny saved is a penny earned.”
It is true that an important, and, at times, the largest component of your net worth could be held in real estate. For most people, however, their real estate investments will be limited to their primary residence. Money Mindset is about ways to create wealth that can translate into income upon retirement.
In a way, I look at the equity in your home as sacred money. We do not want to factor and calculate those dollars for retirement income purposes. It is true that at some point you might downsize your home and use the excess dollars after a transaction like that. At that point, you can factor those dollars into your equation, but until then, look at your home as a sanctuary from the world, not as a short-term investment.
With that being said, when it comes to mortgages, I usually recommend going with a 15- or 30-year fixed mortgage. It may be higher than an adjustable rate mortgage but at least you do not have to worry about the payment potentially going up in the future. Being able to budget around a fixed housing cost is very beneficial.
Of course there are other ways investors can invest in real estate; including buying real estate and then renting it out for income, as well as investing in REITs (real estate investment trusts). These strategies can be lucrative, given certain economic environments if executed appropriately. If executed inappropriately, especially in the area of excess leverage, the investment can have damaging ramifications to your financial situation.
In the next chapter, we’ll discuss taxes and insurance. It’s important for each of us to know the tax system, how we are each affected, and what we are obligated to pay. Insurance protects a person or entity from extreme financial loss or responsibility due to an unfortunate emergency, accident, or negative unforeseen event.