How Much Risk Should you Take? Part 2

Asset Allocation: Part 3

If a questionnaire isn’t going to cut it when it comes to determining your asset allocation, what is?  As I hinted at last time, for the vast majority of people it’s going to be your age and life situation.  There are, however, a few things we need to consider first.

 

1.     Education.  This is really foundational because without the proper set of facts you may be much more willing to make a rash and dumb decision in the heat of the moment.  However, as long as you know the truth and remember it during tough times it should make it pretty easy to stick through whatever is coming your way.  Knowledge really is power and the simple acting of understanding reality can do wonders for adjusting our behavior.

So just remember….If you hold your investments for a long period of time and don’t do anything stupid in the meantime, you will make money.  In any 10 year period since the Great Depression, the stock market has only lost money 1 or 2 times.  In any 15 year period the stock market has never lost money.  So, if you are in it for the long term you can be pretty certain you will make money.  I also recommend you check out John Bogle’s Little Book on Common Sense Investing as a good stating point for your investment education.

2.     Emotion free decisions.  This goes along with education but if we allow our emotions or moods to rule our decisions we will be much less able to make a rational one.  We must be willing and able to step outside of ourselves and look objectively at our situation.  This really isn’t that hard for most people.  Or at least it doesn’t have to be, especially once they get the education piece.

3.     Temperament.  I hesitate to put this one in because it is so hard to determine (It is one of the main things the questionnaires try to answer).  For the majority of people a little bit of education and reassurance is all they will need to stick to their chosen plan no matter the market.  However, if you know that you absolutely cannot handle the risk of losing money then your portfolio should be much more heavily weighted towards bonds than stocks.

Assuming you have the above 3 taken care of, it is time to look at the best way to divide up those assets.  And for this we will also break it down into three things to consider:

  1. Age
  2. Financial Situation
  3. Who will be using the money
According to most of the people I look up to and read, people like John Bogle, Burton Malkiel, Rick Ferri and others, age is the primary factor in determining an asset allocation and risk tolerance strategy.  The theory goes something like this, “The younger you are the more risk you can stomach.  The older you are the less risk you can stomach.”  I really like this approach because it is dealing in facts, not conjecture.  Since one of the main things with investing is ensuring your money doesn’t run out when you need it, as we get closer to retirement we should be increasing our exposure to less risky investments, such as bonds.  Our age is a great barometer to help us do that since it is directly correlated with our retirement date.

The second factor is financial situation.  If you are actively drawing from your investments, you should have much less risk in your portfolio than someone who is actively saving.  This is outside of the normal withdrawals that occur during your retirement.  An allocation based on age will take care of that.  If you are prior to retirement age and are dependent on withdrawing from your investments for any reason, you should consider weighting more heavily toward bonds to minimize the risk of a major down cycle as you are withdrawing.

The last factor is who will be using the money.  If you will be using the money during retirement then as you get closer to it you should get more conservative with your portfolio.  If you are investing the money for your kids or grandkids you should take that into account and use a strategy suitable for them, not you. In those situations you should use the beneficiaries age, not your own.

Ok, now we know age is what we are using barring a unique situation.  But what does that look like practically.  

There are a couple of options:

  1. Age in Bonds
A common way to think about the age factor is to have your age in bonds.  If you are 30, you have 70% equity, 30% fixed income.  If you are 50, you have 50% fixed income.

  1. Age – 10% in Bonds
Another variant is your age -10% in bonds if you want a little more equity exposure.  If you are 30, you have 20% in bonds, if you are 50, you have 40% in bonds.  If you are more conservative by nature another variant of this would be to do your age + 10% in bonds.  

(Remember when doing this to use the age of the person who will be using the assets, whether that is you, your child or your grandchild.)

In the Elements of Investing, Burton Malkiel provides this helpful guide that should work for the vast majority of investors…
 

Whichever way you choose to go with your own asset allocation, use the age factor as a baseline to anchor you and then adjust accordingly.

This is a much better approach than trusting a biased survey whose answers have no better chance of predicting your behavior than you do of predicting the market.

How Much Risk Should you Take? Part 1

Asset Allocation: Part 2

Imagine you woke up tomorrow and you had lost half of your retirement savings. How would you react? How would you feel? More importantly, what would you do? If you’re like me it would probably be some mix of sheer panic, intense anger and projectile vomiting all at the same time. Once that subsides a few days later it is time to make some decisions.

Which would you do?

1.) You sell everything to prevent future losses. Better to cut my losses now than to keep bleeding isn’t it?

2.) You get angry, complain, call your financial advisor and scream at them in an effort to make yourself feel better, but you do nothing else. You do not trade at all. After all, I’ve already lost this much, it can’t get much worse, right?

3.) You check your bank account and savings accounts, pull together every extra dollar that you can spare and you go and buy as much equity as you can. After all, there’s no better time to buy than when stocks are on sale, right?

Whichever of the three scenarios is most likely to be you, your answer to the thought experiment says a lot about your risk profile.  But coming up with one you can live with through the ups and downs of the market can prove rather elusive. Mainly because our brains love to lie to us about how we really are. We love to think we can handle it. We won’t sell. We’ll buy. Until it happens. And we are dropping F bombs as our advisor is trying to remind us that we agreed to the portfolio we are now wanting to chuck off a ten story building.

Swooping in to save the day are firms and financial advisors with their questionnaires. Oh how lucky we are. The way that many firms and advisors have tackled this risk profile dilemma is by having their client answer a series of questions aimed to determine how they are able to handle risk. Questions like,

“If the market dropped 10%, what would you do?”
A. Buy
B. Sell
C. Hold.

Or

“When I invest my money, I am most concerned about:”
A. My investment losing value
B. Equally concerned about my investment losing or gaining value
C. Most concerned about my investment gaining value

This sounds great in theory… Just answer these questions and we will tell you exactly what your risk tolerance is. The problem: IT DOESN’T WORK.

In the Book ‘Your Money and Your Brain’, Jason Zweig quotes a study where they had 100 different people take 6 separate questionnaires. The similarities between the results of the 6 was only 56%. So basically a questionnaire has the same probability of being right as a roulette wheel does. Maybe instead of trusting a multiple choice document we should all just head to Vegas!!!!!!

The study goes on to say that mood is the major determining factor in risk tolerance. How you feel at that moment has a far greater impact on your behavior than anything else. If you are in a bad mood, you are likely to want to take less risk, so you may sell. If you are in a good mood, bring it on, you will likely hold or potentially even buy.

Depending on the day a 20% loss may not seem like a big deal. You just got a promotion at work, you know you will be making more money and so you see this as an opportunity to buy. On a different day the 20% loss may seem like the end of the world. You just found out someone close to you is dying and your own mortality is now staring you right in the face. The thought of losing more money is something you can’t handle, so you sell. Notice how the risk profile questionnaire had no bearing on either decision. And it was unable to predict either of them. At the end of the day, according to the science, our moods rule more than our reason.

This is an AMAZING FINDING! And a testament to the irrationality of decision making. However, it is a finding that is easily eliminated. It seems that simple awareness and knowing this is how your brain works allows you to side-step all of your evolutionary baggage and make a more rational, emotionless decision. And this seems to be the case immediately (as soon as you know or remember.)

And now you know!  But this knowledge leads to more questions. Namely, if questionnaires suck because they are dictated more by our moods than our reason, what is a good means of determining a proper risk profile?

While the best indicator may be to go through a 2008 market crash and see how you react at the bottom of it, I’m guessing none of us want that. So then what else is there? We will discuss some simple, practical determinants next time but for now I’ll give you a sneak peek because you’re still with me 900 words later. The magic secret to risk doesn’t turn out to be so magical at all. The best determinants are going to be your age and life situation. That’s it. Simple, boring, but effective. We will get into the details of it next time.

An Overview of Asset Allocation

Part 1

As we discussed last time, asset allocation is the most important investing decision you will ever make.  Remember Roger Ibbotson, who said that asset allocation accounts for about 100% of performance.  In this post I want to take a look at what asset allocation looks like from 50,000 feet.  Hopefully this will give us some solid ground to stand on as we get deeper and deeper in the coming weeks.  And with that….

At a high level, asset allocation is the amount of equity (stocks) vs. fixed income (bonds) that you hold in your portfolio.  This is a risk based decision.  The more equity you hold, the higher your risk and the higher your expected return.  the more fixed income you hold, the lower your risk and the lower your expected return.  So our first and most important decision is based on risk assessment and risk tolerance.  We will have a post dedicated to those topics but understand that it’s all about managing risk.  If you have a portfolio that is 60% stocks and 40% bonds, then your asset allocation is 60% equity and 40% fixed income.  The easiest way to think about it is through the pie analogy.  You start with a whole pie and your first decision is how to split that pie into the 2 large slices of equity and fixed income.

Next we have to split our large slices into smaller slices called asset classes.  An asset class is an investment type underneath the equity or fixed income umbrella.  Some of these asset classes are things like:
Equity Asset Classes
  • Domestic Stock
  • International Stock
  • Large Cap (Cap = Capitalization, another way of saying Large Corporations)
  • Small Cap (Small Corporations)
  • REITS (Real Estate Investment Trusts)
  • Sector Funds (Health Care, Energy, Financial, Technology, etc.)
Fixed Income Asset Classes
  • Domestic Bonds
  • International Bonds
  • TIPS (Treasury Inflation Protected Securities)
  • Cash
  • Municipal Bonds
  • Treasury Securites

This list is not exhaustive but it gives you the idea and it is representative of the majority of major asset classes.

Once we have chosen which asset classes to include in our portfolio (which we will see from many industry experts later on) our pie looks something like this…

Lastly we must choose which mutual funds or ETF’s (For our purposes ETF’s are basically the same as a mutual fund.  Think of an ETF as a mutual fund that is traded like a stock.) we will use to fill up our asset classes.  For this step, our decision is relatively easy.  We will choose a low cost index fund to match our chosen asset class.  For example:

The list above is mostly ETF’s simply because ETF’s have no minimum investment.  These ETF’s have similar or even lower, in some cases, expense ratios and have the same index fund characteristics of their mutual fund counterparts.  The mutual funds through Vanguard typically have a $3,000 minimum investment.

So there we go… asset allocation is simply the 3 steps of…

  1. Choosing the allocation of Equity/Fixed Income
  2. Choosing the Asset Classes to make them up
  3. Choosing the Mutual Funds/ETF’s to align with the asset classes
Hopefully by now you see that asset allocation is not some complicated, algorithmic, regression analysis that is only possible for financial advisors or finance gurus.  Anyone can do it with the proper education, thought and self-awareness.  The question you should now be asking is ‘How should I answer those questions?’  Which we will get to starting next time when we discuss some things to consider when coming up with your own risk assessment.

2017 Teaser: New series coming soon!

 

Hey Everybody.  I’m back after a hiatus and I’ve got some great stuff for us as we look ahead to 2017.  Over the next few weeks we are going to take an in depth look at the most important investing decision you will ever make: your Asset Allocation (allocation between stocks and bonds.)

As Yale Finance Professor Roger Ibbottson has said of a study he conducted, “We can extrapolate from the study that for the long term investor who maintains a consistent asset allocation and leans toward index funds, asset allocation determines about 100% of performance.”  In other words, index (low cost) funds held consistently over the long term will account for about 100% of your returns.  Sound familiar?  Almost like we’ve said that ad nauseam on this blog. But as powerful as that statement is, the question we have to ask is, Which index funds should we hold?

And that brings us to our new series.  We are going to go in-depth on asset allocation to become informed investors before we make that all important decision.  There are thousands of opinions on this and one of the main reasons that people struggle to tell someone what asset allocation to use is that each situation is different.  But there are some general guidelines that are incredible helpful, and there are also some giants of the industry that have taken a stab at helping out as well.

We are going to look at both.

We will have a look at asset allocation from a high level, we’ll discuss risk and how risk tolerance plays into your decision.  We will talk about asset location, re balancing, the benefits of finding the “right” kind of advisor as well as some strategies to stick to your plan no matter the market.  We will also see what some of the greatest minds in investing recommend.  People like:

 
  • John Bogle, the founder of Vanguard and passive investing
  • David Swenson, Chief Investment Officer of Yale’s Endowment Fund
  • Burton Malkiel, Princeton Professor, author, Random Walk Down Wall Street
  • Warren Buffett
  • Rick Ferri, Index Fund guru and Boglehead
 

It’s going to be epic (think Jim Cramer but with more hair and less buttons!)  This decision will likely be the determining factor in you succeeding at investing or completely shitting the bed.  It seems worthwhile to do what we can to get it right.

We will kick off by learning that no matter what your buddy or financial advisor wants you to believe, asset allocation is not that complicated.  It is actually quite simple.