Getting Started in Asset Allocation
(NOTE: The figures and/or tables mentioned in this sample chapter do not appear on the web version.)
Asset Allocation Explained
ASSET ALLOCATION DEFINED
Asset allocation means dividing your investment portfolio and investable dollars into different asset classes. The theory behind asset allocation is that by splitting your investment portfolio into different types of investments, you can reduce the volatility of the value and returns of your portfolio. In other words, asset allocation can help you smooth out your portfolio value and overall return on investment.
asset allocation division of assets to accomplish personal goals based on age, financial time horizons, financial position, personal risk tolerance, family needs, years to retirement, and so on.
volatility the rise or fall of a market, stock, or bond in a particular period of time. Highly volatile stocks are suitable for only those investors with a higher risk tolerance level.
Your asset allocation program should be the combination and culmination of your individual goals, financial timetable (time horizon), risk tolerance, and investment objectives. These factors and their relative importance to you will help you determine just what percentage of your investment portfolio you want to place at more or less risk, in longer-or shorter-term investments, and even in taxable or tax-free investments. One person's asset allocation model is likely to be different from another person's program. No two asset allocation models are likely to have a large percentage of their assets in the same asset class, aimed at the same goals and objectives, or at the same level of risk.
THE PIZZA PIE ANALOGY
Perhaps the easiest way to begin to describe asset allocation would be to visualize a pizza pie. Imagine that a round pizza pie represents your investment portfolio. Most people cut a pizza pie into eight equal slices. If you follow this model exactly, you would divide or allocate your investment portfolio into eight equal parts. You might put one-eighth (100 percent divided by 8, or 12.5 percent) of your investment portfolio into common stocks and one-eighth of your investment portfolio into bonds, and so forth. This allocation may or may not be a realistic asset allocation for you.
ASSET ALLOCATION ON A PRACTICAL BASIS
Few, if any, of us lead such simple financial lives and have such simple goals and objectives as to be able to neatly fit our investment portfolio into eight equal portions or slices. Each asset allocation will be different based on the individual's or couple's goals and objectives, risk tolerance, and financial position. These topics are discussed in this chapter and in Chapter 2.
Each individual or couple must establish lifestyle objectives and investment goals and objectives and then design a specific and personal asset allocation. Simply putting X percentage of your investments into one asset class with a particular investment objective and investing Y percentage of your dollars in another asset class with a particular investment objective will not necessarily create a properly allocated portfolio. As you will learn in future chapters, you must establish investment goals and objectives and then determine the percentages of your investment portfolio to invest in each asset category.
Your asset allocation must clearly reflect your goals, address your objectives, fit your investment and life cycle timetable, and otherwise do only what you need to do and get done with your money. Asset allocation is very personal and will be ineffective if you fail to design your asset allocation program to meet your needs.
To maximize your wealth and develop an asset allocation program that will yield the most value to you and your family, learn the concepts explained in this book and follow the action steps to develop your own personal asset allocation model.
Before you can begin to divide your investment capital into slices appropriately, you must complete a great deal of self-examination. Keeping in mind that asset allocation is a personal endeavor and an evolving process, each person will have different goals and objectives and different financial circumstances, all changing over time.
FINANCIAL GOALS AND OBJECTIVES
First, consider your financial objectives. In other words, what would you like to accomplish in your lifetime? Everyone has unique and individual personal goals and objectives. You may want to live on a tropical island in the Caribbean and play golf twice a day; you may want to live on a boat and sail the seven seas; perhaps you want to donate your money to your alma mater, church or synagogue, hospital, or other nonprofit organization; you may want to educate all your grandchildren through grad school; or maybe you'd just as soon spend all of your money during your lifetime. You see, your financial objectives are just that: yours.
Here are a few common financial goals:
Don't be ashamed, embarrassed, or even concerned about what anyone, including your own personal financial professional, thinks about your financial objectives. What you want from your money is your choice and it's your adviser's job to show you how to accomplish those goals based on the assets and income available, as well as your personality. Setting your financial objectives and goals should be about as selfish as making out your own will. The only consideration is you and your wishes. Obviously, your objectives should be realistic in the sense of whether they can be achieved; otherwise this will be a fruitless exercise.
- Buy a home.
- Buy a new car.
- Buy a boat.
- Build a swimming pool.
- Take a vacation every year.
- Travel to exotic locations.
- Establish an emergency fund.
- Start your own business.
- Fund your children's college education.
- Fund your children's weddings.
- Build enough wealth to retire comfortably.
- Build enough wealth to retire early.
As you decide which life cycle phase you are in and which phase you want to plan for, read Chapters 9 through 14. In each chapter, we profile people at a different stage in life. We apply asset allocation to financial objectives relevant to that group.
If you are single, financial planning and asset allocation may be a relatively straightforward exercise. When your financial plan includes a spouse or partner, and you may face the responsibility of caring for others such as children, parents, and grandparents, planning becomes much more complicated and involved. Typically, in these cases you will need more financial resources and discipline to accomplish your financial goals and objectives.
When you plan your financial future with a spouse or partner, the two of you must conduct lengthy, candid, and in-depth dialogue. As a first step, each partner should analyze his or her own preferences, biases, goals and objectives, and anxieties. Then both of you, individually, should commit to paper your thoughts in those areas.
These discussions can become heated and sometimes upsetting, especially since proper financial planning entails considering your personal fabric and personality. With most topics, and especially money, people cling to their personal goals and feelings. Sometimes, these discussions can become contentious. To the best extent possible, it is important to maintain a reasonable perspective and try to focus on the fact that your collective purpose is to advance your family and your well-being together. In some cases, we have recommended that couples divide their resources. Each partner would have a personal allocation for a portion of their investment assets and they would have a common plan and allocation for the remainder of their investment assets. Generally, it is more efficient, economical, and positive for family members to pool their resources and work toward common and shared goals and objectives.
ASSET ALLOCATION FACTORS
To create the optimal asset allocation program, you must consider a number of factors and components. In the preceding section, we discussed personal goals and objectives. To a large extent, financial goals and objectives are the overriding force in determining an asset allocation. In effect, the more ambitious and costly your personal goals, the more money you have to accumulate in order to realize those goals and objectives. For example, if you would like to retire and be in a position to spend $100,000 per year, that is a more ambitious goal than wanting to be in a position to spend $50,000 per year. The former goal requires more money and therefore a longer investment (wealth accumulation) horizon, greater savings and investment earlier on and probably over time, and perhaps more aggressive (risky) investing.
In other words, to achieve higher financial goals, you will probably have to strive to earn higher investment returns. This translates into allocating your assets more heavily into riskier asset classes such as common stocks.
However, other factors are significant with respect to creating your asset allocation program:
- Life expectancy.
- Financial milestones.
- Responsibilities and financial obligations.
- Time horizon.
- More aggressive investing.
- Conservative approach.
- Financial position.
- Income sources.
- Expected market returns.
- Risk tolerance.
Your own age, your spouse's or partner's age, and the ages of your children (and any others who rely on you for financial support) are very important factors in financial planning and asset allocation. The younger you are, the more time you have available to take advantage of the power of compound returns, the greater your risk tolerance, and the more ability you have to recover from financial mistakes and losses.
You should visit your doctors to determine your life expectancy and study your family history. You should gain a sense of your life expectancy and any hereditary diseases or conditions you may face. Once you assign a financial cost to any ailments, you can estimate your likely financial needs. As appropriate, you can alter your financial plan to prepare for these possibilities.
Earlier in this chapter, we listed financial goals, including buying a boat or building a swimming pool, funding your children's education, funding your children's weddings, and retiring. The best way to achieve your financial goals is to assign a specific date to each goal. Then tailor your portfolio and asset allocation to meet these goals. Suppose you want to retire when you reach 55 years of age and that is 14 years from now. In order to reach your goal, you have to allocate your assets to build enough wealth to fund your retirement years, which would be likely to span 25 to 30 years (with a life expectancy of 80 to 85 years). In the coming decades, you will probably have to plan for a retirement that may be longer than your total working life. Assuming you are 41 years of age and continue working up to age 55, you will earn a paycheck for the next 14 years and must dedicate a certain amount of your current income to build your retirement assets. You can handle any goal in this fashion.
Responsibilities and Financial Obligations
Your personal responsibilities and financial obligations will play an important role in determining how much money you have to invest and how you should allocate your assets. More and more families are becoming multigenerational households. For example, parents, grandparents, aunts, and uncles in their 60s, 70s, 80s, and, as we move on into the next century, still-healthy relatives in their 90s and 100s may live with you. And let's be sure to consider that ever-growing phenomenon of your grown children alone or with their entire nuclear family returning to the nest, but who still need your care and financial support.
In the previous few paragraphs, we discussed the time horizon between now and when you want to realize your goal. In the retirement example, there are at least two time horizons mentioned. The first is that the person wants to retire in 14 years. This has implications about how much money this person needs to save and invest in order to achieve the desired retirement lifestyle. The second is that the person expects to live for 25 to 30 years in retirement. This implies that the money has to last at least 25 to 30 years (this ignores how much money the retiree would like to leave heirs). The longer your time horizon to accumulate wealth, the more time you have to build enough wealth to achieve your goals. Suppose you begin saving and investing money today; the longer your time horizon, the less money you have to invest now to achieve your financial goal. Suppose you have an opportunity to make one lump sum investment today that yields 8 percent forever, and you want to accumulate $1 million in 40 years. Table 1.1 illustrates the power of compound returns. It shows the lump sum investment you need to make today in order to accumulate $1 million, assuming an investment yield of 8 percent for the entire time horizon (investment period). Notice from the table that if you want to accumulate $1 million in 40 years, you have to invest $46,031 today. If your time horizon is only 10 years, your required investment increases to $463,193, a sizable difference. The point of the example and the following two examples is that the longer your time horizon, the less money you need to invest today to achieve your financial goal.
More Aggressive Investing
If you could assume more risk and make an investment that earns a 10 percent rate of return, you could make a smaller lump sum investment. (See Table 1.2.) For the 40-year time horizon, the $46,031 investment drops to $22,095. For the 10-year time horizon, the $463,193 lump sum investment drops to $385,543, still an enormous sum of money. Table 1.2 illustrates the lump sum investment you need to make today in order to accumulate $1 million, assuming an investment yield of 10 percent for the entire time horizon (investment period). Notice from the table that if you want to accumulate $1 million in 40 years, you have to invest $22,095 today. If your time horizon is only 10 years, your required investment increases to $385,543. Generally, to achieve higher returns, you have to assume incrementally higher degrees of risk. Depending on your personal circumstances and situation, you may or may not want to undertake this additional risk.
Alternatively, you could adopt a more conservative approach. Suppose that you expect to achieve the 8 percent rate of return. However, you want to hedge your bets and ensure that you achieve your financial goal-accumulate $1 million in 40 years. You decide to assume that you will earn only a 7 percent rate of return. Accordingly, at a 7 percent rate of return, to accumulate $1 million in 40 years, you should invest $66,780 today. (See Table 1.3.) You can use a financial calculator or computer spreadsheet program that computes present and future values to help you calculate investment amounts. Or, work with your accountant, financial planner, or investment adviser. Table 1.3 illustrates the lump sum investment you need to make today in order to accumulate $1 million, assuming an investment yield of 7 percent for the entire time horizon (investment period). Notice from the table that if you want to accumulate $1 million in 40 years, you have to invest $66,780 today. If your time horizon is only 10 years, your required investment increases to $508,349. Alternatively, you could make the lump sum investment today and make additional lump sum investments in years two, three, four, and so on. This way, you will have more money working for you and you are more likely to achieve your financial goals. This also provides you with a cushion in case you do not realize your expected returns.
Your financial position also plays a major part in determining your asset allocation. To the extent you have accumulated significant wealth, it should be easier for you to achieve your financial goals. To the extent you earn a relatively high current income, it should also be easier for you to achieve your financial goals. Of course, this depends on your spending habits and cost structure. In general, the more money you have and the higher your income, the more likely you are to achieve your financial goals. Of course you have to invest your money wisely.
In discussing financial position we raised the point that the higher your income, the more financial power you have to invest more money and realize your financial goals. Regarding retirement planning and setting financial goals, we already considered the wealth you will accumulate. Several other points to consider are your pension, Social Security, and any inheritances you may receive. Social Security and pension payments are designed to provide additional income to you during your retirement. As with all investments, it is important to analyze the creditworthiness of the payer. In other words, how likely is it that these sources will be in a financial position to meet their payment obligations? The press mentions that the U. S. government is taking steps to save the Social Security program and ensure that future generations will receive payments. To the extent you rely on Social Security, your financial health depends on the financial strength and health of the Social Security system. You should monitor the Social Security Administration's financial condition and plan your own saving and investment program accordingly. Similarly, your employer or your union may be responsible for paying your pension benefits when you retire. You'll want to monitor the financial health of these parties and plan your finances accordingly.
Expected Market Returns
Earlier in this chapter, we discussed the effect of different rates of return on an investment or on your investment portfolio (see Tables 1.1, 1.2, and 1.3). If you assume that your investment portfolio will yield 10 percent and you invest accordingly, and your actual returns equal only 7 percent or 8 percent, your wealth will be less than you expected. You may fall short of your financial goals. Similarly, the long-term (1926 to 1997) rate of return on the S&P 500 index of common stocks has been 11 percent per annum. (Used with permission. (c) 1998 Ibbotson Associates, Inc. All rights reserved.) By comparison, the rate of return on the S& P 500 index of common stocks has been 37.43 percent in 1995, 33.36 percent in 1996, and 23.07 percent in 1997. (Used with permission. (c) 1998 Ibbotson Associates, Inc. All rights reserved.) These current returns substantially exceed the long-term average rate of return. Therefore, it is reasonable to assume that future returns will revert to the long-term mean (average) and be less than 25 percent to 30 percent per annum. Make sure you invest enough money over time to ensure that you achieve your financial goals in light of actual market returns that may be less than your expected returns.
Your tolerance to assume risk will play a large factor in how you allocate your assets. In Table 1.2, we considered an investment that yields 10 percent rather than the initial 8 percent rate of return. In general, the 10 percent investment inherently bears more risk than the 8 percent investment. Two ways to view risk are as volatility and probability of losing money. In other words, the 10 percent investment is likely to be more volatile than the 8 percent one: The investment value will fluctuate up and down more widely. Most likely, the 10 percent investment carries a higher probability that you will lose some or all of your investment than the 8 percent investment.
Over the long run, based on past performance, the stock market has posted the highest returns among stocks, bonds, and money market investments. As you might expect, the common stock asset class bears the highest risk or volatility of these three categories. Your tolerance for risk will help you determine whether you want to allocate more of your investment portfolio toward the 8 percent, 10 percent, or 7 percent categories.
If you don't like volatility and risk, you may want to gravitate towards the 8 percent and 7 percent yielding (lower-risk) assets than the 10 percent yielding assets. This implies that the conservative person's asset allocation will be different from the aggressive person's asset allocation.
HOW TO SPLIT YOUR INVESTMENT PIE
Every person reading this book, at one time or another, may have commuted to work either by car or public transportation, flown in an airplane, ridden on an elevator, or bought a lottery ticket. In each of these examples, you took some risk. But, the real question is . . .when you assumed those risks, did you know, in your heart of hearts, that you could have sustained an injury or lost all the money you placed on the line?
We all have 100 percent risk tolerance as it applies to some of our money. The question is how much of our money are we comfortable placing at complete and total risk. While every investment, action, and inaction contains some degree of risk, the key is to analyze those risks and allocate our investment portfolio accordingly. Allocate only those dollars you are ready to lose to the highest-risk investments and work your way down the risk ladder with the rest of your investment portfolio.
Just what percentage of those dollars you have worked a lifetime to accumulate and feel comfortable placing at high risk is a personal and individual decision. Perhaps you should look into the mirror and ask yourself, "How many of those dollars am I ready to lose?" When you analyze yourself and your tolerance for risk, you will gain a new and more practical appreciation for risk. We all have a certain level of risk tolerance; it's just a matter of knowing what our level really is.
Since risk is such an important aspect of asset allocation, please study Chapters 2, 5, 6, and 7 for a more in-depth discussion of the various kinds of risk inherent to each category of investment. You must understand the nature and characteristics of every investment you make before you invest your money.
ALLOCATION VERSUS DIVERSIFICATION
Asset allocation is those boxes or baskets in which we make certain investments. In other words, asset allocation means how we divide up our investment portfolio across different asset classes or investment types.
Diversification means purchasing a number of investments or securities within an asset category or class in order to reduce investment or unsystematic risk (this is explained further in Chapter 2).
Suppose John, an individual investor, decides to allocate 15 percent of his investment portfolio to generate tax-free income (we discuss tax-exempt municipal bonds (munis) in Chapter 6 in more detail). John's portfolios net worth equals $1 million, so 15 percent equates to $150,000. The 15 percent or $150,000 represents the percentage of John's portfolio he allocates toward investing that generates tax-exempt or tax-free income.
diversification spreading your assets among different securities (growth, income, etc.) or different quality securities (within an asset class or mutual fund) for the purpose of spreading out your risk. The opposite of diversification would be having all your eggs in one basket.
unsystematic risk risk from competition or obsolescence rather than from market forces or "interest rates." See systematic risk.
Within that 15 percent allocation or basket, John might own:
In this example, John allocated $150,000 of his investment portfolio toward his personal investment objective of generating tax-exempt income. Within that category, he diversified his investments among bonds issued by different municipalities and selected bonds of different maturities. This sort of diversification, within the asset allocation model, accomplishes the goal of reducing unsystematic or specific investment risk.
- $50,000 in AAA-rated general obligation bonds.
- $50,000 in A-rated revenue bonds.
- $25,000 in Baa-rated bonds of a small municipality.
- $25,000 in nonrated bonds (junk bonds) of an even smaller community.
The maturities selected would match the average maximum yield available at the time you invest, based on the then current yield curve. For example, yield may peak in five to six years before flattening or even declining. Those maturities would produce the best yields available at that time.
As you will note from the individual components of this model portfolio, there is consideration given to risk tolerance as well. Each of the bonds listed bears a different credit rating and some are safer than others. Some are higher-or lower-rated bonds; some are from larger or smaller issuers, and one issue is highly risky as indicated by the fact that the security is nonrated. A closer look might even reveal bonds with different maturity dates (addressing that personal financial timetable we discussed earlier); some of the bonds might pay interest at different times of the year and some might also be tax-exempt federally and at the individual state level as well.
Were no consideration given to diversification, we would simply have bought $150,000 in face value from a single issuer, with a single maturity date, all paying interest in the same months and all equally rated by Moody's Investors Service or Standard & Poor's, two nationally recognized credit rating agencies.
Asset allocation coupled with proper diversification can mean the difference between meeting your goals and objectives and missing the mark. Placing your portfolio at greater risk than you can tolerate may result in your losing sleep and not having enough money available to meet your personal financial timetable. Similarly, assuming too little risk may result in your losing too great a percentage of your wealth to inflation, and this may mean you fall short of your financial goals.
WHY ASSET ALLOCATION IS ADVANTAGEOUS
In this chapter, we explained the concepts and nature of asset allocation. We have provided examples in order to illustrate the mechanics of asset allocation. To summarize, here are the four major benefits and advantages to asset allocation:
1. By establishing your own personal asset allocation, you can develop and implement your own financial plan to suit your needs and personality.
2. Proper asset allocation means making a financial plan and examining the following factors to achieve the optimal portfolio composition and risk-return trade-offs. Once again, the key consideration in an effective asset allocation program is you:
3. A disciplined approach to investing and managing your money and a well-thought-out and developed asset allocation program should take a lot of the guesswork out of investing money.
- Your financial timetable.
- Your personal financial objectives and goals.
- Your financial position.
- Your risk tolerance level.
- Your ability to understand the investments recommended.
- Your estate concerns.
- Your tax bracket and estate tax considerations.
A quick look at the over 8000 mutual funds existing today will clearly show that there are an infinite number of investment choices and types of investment vehicles. By establishing an asset allocation program or portfolio blueprint, you will be well ahead of the game regarding which types of investments and mutual funds you should select for your investment portfolio.
4. Asset allocation combined with prudent diversification will help you to smooth out the volatility of your investment portfolio and smooth out your overall rate of return. In other words, these two strategies used together should help you to increase your return while taking on less risk.