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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 [...]]]>
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.