So you know that list of things you know you should do but never seem to have the time to get to? Well that happened to me. I have a very old 401k from a previous employer that I know I should have rolled over years ago, but I always seemed to find things that were more urgent and important . It’s one of those things I always meant to get around to but never did.
But I finally did last week. It took a phone call, a signature and a fax but now I have my old 401(k) rolled over into my IRA. I thought the hard part was over, but sadly it was not. Rolling it over was the easiest part.
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The hard part came when my broker sent me a list of possible funds I could invest in. I’m looking at a list of 20-30 options and scratching my head. First off, I have never even heard of most of these and secondly I don’t know how much of my portfolio to allocate to each one. I knew if I was scratching my head in confusion at what to do some of my readers might be feeling the same way.
Most investors don’t even have a plan for their portfolio. They randomly pick a something that catches their eye, maybe they like the name or think they heard about it once. 40 years later, they complain about the government, taxes, and the media for their poor investing returns.
The way in which you divide the investments in your portfolio is called asset allocation. There are three types of assets you can choose for your portfolio: stocks, bonds and cash. You may be saying to yourself well I’ve also heard of things like ETF’s, annuities, T-bills and so on. Those are all types and styles of the three main investment options. Each carries its own risk and reward characteristics. The types of assets you choose and how much you choose to invest in each of those will largely determine your overall portfolio risk and reward. Here’s how to pick the best asset mix for you…
The two most important factors that determine the success or failure of an investment portfolio mix are time and risk tolerance. These two factors will help you decide whether to invest aggressively or conservatively. The more time and risk tolerance you have the more aggressive you are going to want to be in your investments. The longer an investor has for their portfolio to grow the better chance they have of netting a sizeable nest egg for retirement. That’s why we tell kids entering the workforce to sign up for a 401(k) immediately.
To determine your risk tolerance level ask yourself this question. What is your goal? Are you looking for growth to significantly build your nest egg? If so then you’ll need to have a high tolerance level. This is true mostly of younger investors who have many years before they plan on retiring.
If your answer was more along the lines of wanting to build another income source for retirement then you know your risk tolerance would be lower. For some, social security and 401(k) income aren’t enough to live off of in retirement. If this is you then you want a less risky portfolio that is still growing but provides protection against losing the gains you’ve acquired over the years.
A more conservative answer might come from someone who is very near or already in retirement. These types may be currently living off the money in their nest egg and need an asset mix that will hold its value over time.
Each of these types of investors requires a different mix of assets in their portfolio to accomplish their goal. Let’s look at the characteristics of each asset and what they mean to your portfolio.
Stocks –These are the riskiest of the three asset classes because their values fluctuate much more wildly. When you own a stock you basically own a tiny piece of ownership in a company. When a company does well, their stock goes up and you realize gains. When a company’s performance falters, the stock does too and the value of it drops. Stocks are also called equities or shares and historically they have earned higher returns for investors over the long term than the other asset classes.
Bonds – These are a fixed-income investment through which an investor loans money to a company or government entity. They work much the same way as a bank loan. You loan an entity or company money and in exchange they agree to pay you interest and return the principal back to you, the bond holder, after a predetermined amount of time. This is why they are considered a much more conservative investment than stocks, but less conservative than cash. Bonds have seen less price fluctuations over the years than stocks and therefore offer less risk. On the other hand, their overall growth potential is lower than that of stocks.
Cash – This is the most ‘stable’ of all three asset classes in terms of price volatility. Assets like these are ones that can be quickly and easily be converted to cash. It’s also referred to as liquidity. Bank accounts and treasury bills are examples of cash equivalents. They are the most conservative of all the asset classes because there is no room for these investments to grow in value; they basically just try to keep up with inflation so you don’t lose money.
There is no clear answer on how much you should invest in each of these types of assets. What works for one person won’t necessarily work for someone else. Each person’s decision largely depends on their overall investment goal, time frame and tolerance for risk. Thankfully there are some general guidelines we can all follow.
The longer you have to invest the more aggressive your investments should be. Investors with 20-40 years to retirement should put a large portion of their portfolio in risky assets like stocks because they will have enough time to weather any volatility in the market. On the other hand, if you are 10 years or less away from retirement then you should allocate more of your assets towards conservative investments like bonds and cash equivalents. Your portfolio won’t have enough time to recover from market fluctuations (like what happened in 2008) and recoup any losses.
Investors who have a significant amount of years before they plan on retiring and have an interest in significantly growing their portfolios should invest anywhere between 90-100% in stocks. Then as the investor ages and their priorities change, they should shift more and more of their assets towards more conservative assets like bonds. The change should be gradual and slow with only major moves coming every decade or so.
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Everything I learned about asset allocation I learned from a street vendor in Times Square…I just didn’t know it. On a trip to New York city many moons ago I noticed many street vendors sold items that didn’t seem to go together. One such vendor sold umbrellas and sunglasses. When I asked him why he did this he said it was so he could insure he would always have sales. If the skies are clear and the sun is out, customers are buying sunglasses from him. If it’s cloudy and raining out, people buy umbrellas. This way he is always making sales, no matter what happens. This principle won Harry Markowitz a Nobel Prize in 1990. He suggested investors would be better off building portfolios with assets that had very little relationship with each other. This diversification could result in reduced risk without reducing returns.
Before Markowitz formalized Modern Portfolio Theory, financial planners recommended investors pick securities based upon their individual risk and reward characteristics. Standard investment advice was to pick securities based on its personal performance and then construct a portfolio full of these. Using this advice, investors might find that oil stocks all offered good risk-reward characteristics and compile a portfolio made up entirely of these. But as we all know that is foolish advice. We have been taught to “not put all our eggs in one basket”. Markowitz instead proposed that investors build portfolios based on their overall risk-reward instead of choosing individual securities that each individually has good risk-reward characteristics.
I want you to take a look at your portfolio and see if your goals, timeline and risk tolerance level match up with your mix of assets. These three factors change over time and so should your asset allocation.
Until next time…
Keeping Money In Your Pocket,