Generation Y Investor » Asset Allocation

Composure: The Key To Risk Tolerance

Stephen Kline — Tue, 03 Nov 2009 01:42:13 +0000

I’ve already mentioned in a few posts that it’s vital to have an asset allocation that matches your time horizon and risk tolerance. Figuring out your time horizon is simple enough, but things get a little more difficult when it comes to assessing your risk tolerance. Some advisors will point you to a standard questionnaire that is suppose to measure your ability (or inability) to handle risk. The problem with these quizzes is that they try to measure an individual’s emotional response to varying scenarios with intellectual questions. How you respond to a question about a hypothetical portfolio loss of 50% is probably quite different then how you actually responded last year when the markets were plummeting day after day.

The following article examines how the best gauge of risk tolerance is actually the level of composure one has when something unexpected occurs: Tune In, Chill Out

“People say they’re willing to lose 20%, then they lose 2% and they panic. A more meaningful indicator is composure — your short-term, emotional reactions to unpredictable and uncertain events, such as the market’s ugly sell-off on Friday. How will you handle yourself in the heat of battle? Far too many investors discovered in 2008 and early this year that losing money in quick, sharp cuts was more than they could bear. Those thoughtful risk-tolerance quizzes got shredded when stocks went into free fall. Panicked investors sold what they could, often at any price.”

Some comments on Buffett’s, “Be fearful when others are greedy, and be greedy when others are fearful” quote…

“There’s a good reason why there aren’t more Buffetts among us: Buffett is not only more risk tolerant, he’s more composed. When the shooting starts and money is on the line, Buffett comes across as cool and unemotional. And he fires back. Think Clint Eastwood with a calculator.”

On how you can increase your composure…

“First, commit to an investment policy with a long-term or big-picture focus that recognizes there will be major pitfalls along the way. This is your battle plan. The most effective policy statement lays out objectives. These include return goals — how much money you’d like to make — and the potential obstacles to that happy outcome. In this way, you get a sense of how emotions dictate your actions.”

“Second, divide your wealth into different mental accounts with varying degrees of risk. Investors should not be diversifying asset classes; they should be diversifying risk.”

How Not To Invest For Retirement

Stephen Kline — Thu, 22 Oct 2009 23:00:55 +0000

Successful investing isn’t easy. In addition to having a basic level of financial competency, successful investors must also exhibit a high degree of discipline and emotional control. Without all three of these characteristics an investor’s returns are likely to disappoint. After all, one can be as financially astute as Warren Buffett or George Soros; however, if he or she lacks the emotional control and poise to go against the herd then they’ll never have great success.

As a case study, I bring you the story of The Simkin family: Getting back on the retirement horse

“Jason and Patty Simkins, both 40, have saved next to nothing for retirement in the past year. They were rattled by the rocky market, which caused the value of their portfolio to tumble 40% at its low point.”

“So when Jason switched jobs last fall… he neglected his new 401(k). Saying, “I didn’t want to throw money into it if it was just going to be lost.”

“But now they’re disappointed to have missed out on additional gains from the market’s rebound.”

“Realizing they need to catch up on retirement (and, with two kids, save for college), they’re ready to put a toe back in the water.”

I think all of us can relate to The Simkin’s story. Last year as the markets were being pummeled day after day, even the most iron-willed of us surely contemplated exiting the markets, or at the very least stopping our ongoing contributions. The problem with this, as the Simkins indicated, is that they’ve consequently missed out on the juicy 60% returns the market has put in since bottoming. Now, only after this enormous rally, are they looking to restart their retirement plan contributions. This my friends is not the modus operandi of successful investors.

Instead, I offer the following plan to passive retirement investors…

First, familiarize yourself with the concept of asset allocation. Once familiarized, develop a diversified asset allocation that coincides with your risk tolerance and time horizon. (note: you’re probably less risk tolerant than you think)

Second, contribute to your retirement accounts using a dollar-cost averaging plan. This entails investing a fixed amount of money on a monthly or per paycheck basis. These contributions should match the asset allocation you created in step one.

Third, every quarter check up on your portfolio and revisit your asset allocation. Are your current holdings in-line with your plan? If not, rebalance your portfolio so it isn’t too aggressive or conservative.

Finally, once every year you need to reexamine your risk tolerance and time horizon. If they’ve changed, chances are you need to modify your asset allocation.

There you have it. Following these simple steps will give you a disciplined financial plan that you can implement in an emotionless manner. Give it a try and your odds of being a successful long-term investor are high.

How Long Will This Rally Last?

Stephen Kline — Sat, 22 Aug 2009 15:01:03 +0000

The markets have been in a sustained rally since hitting the March lows. Since that time, the S&P 500 has climbed more than 50% from the bottom. While we’ve seen some noticeable improvement in the economy since than, there are still many ominous signs that make me weary.

Firstly, second quarter earnings were largely viewed as a success. The majority of S&P 500 companies managed to beat analyst’s earnings estimates. This is a good thing. However, the majority of these earnings beats were due to cutting costs rather than better than expected revenues. All in all this isn’t necessarily a bad thing, provided that top-line revenues begin to increase in the upcoming months. If revenues don’t begin to increase, than one had to question how long firms can continue cutting costs to drive earnings.

My second reason for being cautious right now is the high degree of bullishness on the housing market. Recent data has indicated home sales have increased significantly month over month and many have claimed that the housing market is beginning to bottom out. This bullishness seems unwarranted to me because only the low priced homes are seeing an increase in sales/price (think foreclosures). The mid to high end of the housing market is still stagnant and prices have nowhere to go but down.

Another reason to be bearish on housing is the first time homeowners credit. Towards the peak of the housing bubble our country saw the greatest percentage of Americans in history own their own home. Put in a different perspective, we had the fewest percentage of potential first time buyers in history because everyone who wanted a home had already purchases one. Yes there is a good portion of people right now who were/are looking to purchase a home. However, most of these people are rushing to close on homes right now in order to take advantage of the government credit.

At first you may think this is a good thing. But in reality all the first time buyers credit is doing is front-loading all the potential demand for housing that’s left (aka stealing from future demand). I wouldn’t be surprised to see housing take another leg down starting in November/December after the credit has ended and demand from first time buyers wanes. (Note: A similar argument can be made about the cash for clunkers program front-loading demand for new vehicles).

My final reason to question the extent of this rally is that it’s being fueled largely by hedge funds and institutional buyers who are being forced to buy stocks because they were under invested at the bottom. When you’re running a hedge fund or mutual fund your investors are always comparing your returns to those of other hedge funds and mutual funds. Therefore, if you were sitting in cash and missed the huge rally since March you’re going to desperately try and catch up to your peers who have benefited from the rally.

So despite some improvement in the economy since the lows, I still feel the need to advise caution. I wouldn’t recommend selling all your stocks and hiding under your bed. Just as I wouldn’t recommend jumping full steam onto this rally. Make sure you have a proper asset allocation that matches your risk tolerance. Also, take a look at your current asset allocation and make sure it’s inline with your target allocation. The big rally of the past few months may have caused your portfolio to become over-allocated towards stocks. If this is the case, rebalance your portfolio by selling some stocks and buying bonds or redirect new contributions into your fixed income investments.

Above all, remain vigilant and cautious about this or any other rally in the stock market. Remember, risk goes up as stock prices increase. Don’t become complacent.

Has Investor Risk Tolerance Changed Forever?

Stephen Kline — Sun, 22 Feb 2009 20:28:41 +0000

The historic drop in the markets that has taken place over the past year has even the most seasoned investors shaken. Very few investors have ever seen a bear market of this stature during their investing careers, and one has to wonder whether overall risk tolerance has changed for good.

Personally speaking this bear market has reinforced the idea of having a proper asset allocation. I’d say even the most aggressive investors with long time horizons would benefit from having a minimum of 10% of their portfolios in bonds to lessen volatility. For those investors closer to retirement, a portfolio consisting of 40-50% bonds would be more appropriate. A proper asset allocation won’t prevent you from taking losses during severe bear markets, but it will ensure that you live to fight another day.

Here’s an interesting piece from the New York Times that examines how our current crisis is changing the way investors look at risk.

K.I.S.S. – Target Retirement Funds

Stephen Kline — Thu, 30 Oct 2008 23:36:44 +0000

Keep It Simple Stupid

In my previous post about asset allocation I talked about how important it is to have a diverse mix of investments that match your risk tolerance and time horizon. I also explained that it is necessary to shift this mix of investments into less risky assets as you get closer to retirement. For those of you who don’t have the time or desire to actively manage your portfolio’s asset allocation, target retirement funds may be right for you.

Target retirement funds are mutual funds that hold a set allocation of stocks, bonds and cash based upon the fund-holder’s expected retirement date. As time goes by, the allocation of investments becomes more conservative by decreasing it’s exposure to stocks and increasing it’s exposure to fixed income investments. For example, in my IRA I hold Vanguard’s Target Retirement 2050 Fund. Currently this fund has the following asset allocation…

U.S. Stocks – 72%
International Stocks – 18%
U.S. Bonds – 10%

This aggressive asset allocation will gradually get more conservative as I get closer to retirement. By the time I’m 60 and a few years away from calling it quits the fund’s holdings will look like this…

U.S. Stocks – 48%
International Stocks – 12%
U.S. Bonds – 40%

By gradually become more conservative target retirement funds offer a simple way for investors to ensure they have a proper asset allocation based on their age/time horizon. All the investor has to do is decide when they want to retire and then pick the fund that’s closest to that date.

Target retirement funds are also a great way to start investing because they allow you to have a diversified portfolio of stocks and bonds all in one fund. Not only is this convenient, but it also helps young investors who may not have enough money to open multiple funds. (Many funds require that investors have at least $3,000 to open a new account) One final benefit of these funds is that they tend to have low fees and expensive ratios. Keeping fees and expenses to a minimum is vital to investors hoping to achieve maximum returns.

To learn more about target retirement funds you can visit any of the major mutual fund companies’ websites. Personally I’m a fan of Vanguard’s funds, but Fidelity and T. Row Price also have some nice options as well.

Cramer’s Panic: A Lesson on Asset Allocation

Stephen Kline — Fri, 24 Oct 2008 01:29:40 +0000

Cramer’s Panic

Cramer

On October 6th Jim Cramer the host of CNBC’s “Mad Money” appeared on The Today Show and told investors, “Whatever money you may need for the next five years, please take it out of the stock market right now, this week. I do not believe you should risk those assets in the stock market right now.” While I agree with Cramer’s statement in principle, my first question would be, “Why was this money in stocks to begin with?”

Instead of advising his viewers from the beginning that stocks are volatile and are only appropriate for long-term investments (5+ years), he waited until the market dropped 40% before doing so. IMO there’s no reason why investors should be booking 30-40% losses on money they’ll be needing within a few years.

Asset Allocation Defined

The key to avoid having to take massive losses like this is maintaining a proper asset allocation. Asset allocation in the nutshell is how an investor spreads their money across different asset classes (ie: stocks, bonds, cash) within their portfolio. It’s a way of diversifying your portfolio and smoothing out the volatility/risks of investing. Holding a mix of investments helps reduce risk because when one asset declines, that decline can be offset by a rise in a different non-correlated asset. Over time the ups and downs of the market even out and investors see steadier growth of their portfolio.

The asset allocation of an investor’s portfolio should reflect the investor’s time horizon and risk tolerance. Young investors like you and I can afford to keep the majority of our retirement portfolios in stocks. We have nearly 40 years until we’ll need this money, and would like it to grow as much as possible. However, money that is needed within the short-term should be kept in less risky assets such as bonds, CD’s or money market funds.

Here’s a useful asset guide

Asset Class Risk Timeframe

Stocks High 5+ Years

Bonds Medium 2 – 5 Year

CDs/MM Low < 2 Years

What should my asset allocation be?

Their are many ways investors can go about setting their asset allocations. One of my favorite rules of thumb comes from Vanguard’s legendary founder John Bogle. John Bogle preached that the percentage of stocks in an investor’s portfolio should be roughly equal to 100 minus their age. For instance, a 25 year old investor should have a portfolio of 75% stocks and 25% bond’s/cash. I think Bogle’s rule of thumb is perfect for investors who tend to have a lower risk tolerance. For more aggressive investors like myself, I suggest a modified version of Bogle’s rule where the percentage of stocks is equal to 110 minus their age. The beauty of following these simple rules is that the investor’s portfolio will gradually become more conservative as they age. This way, when we are older and closer to retirement a decline in the stock market will have less of an impact on our portfolios.

Following this asset allocation strategy will prevent you from having to sell your stocks at depressed levels in a bear market as Cramer advised. Now you know that money needed in the short-term should be mostly in cash equivalents, and money in stocks shouldn’t be needed for at least 5 years. By having a proper mix of asset classes in your portfolio you can greatly reduce your risk while still achieving solid returns.

Mutual Fund companies like Fidelity and Vanguard have whole lines of target retirement funds that follow the strategy I talked about in this post. I’ll be providing more information on these funds in a future post since I believe they are a great way to start investing for retirement. In the meantime, I hope you’ve learned something worthwhile from this post. If this information prevents just one Gen-Y Investor from being too heavily weighted in stocks 40 years from now then I’ve done my job.