Selecting the Right Asset Allocation – Part 2

Jane Young, CFP, EA

Jane Young, CFP, EA

Your asset allocation is the basic structure of your investment portfolio defining the target percentage you want to hold in different categories of assets.   Start creating your asset allocation by deciding how much you want to invest in the two major categories, stock mutual funds and interest earning assets.  Next break your allocation down into more specific categories including cash, CDs, bonds, large cap stock, mid-cap stock, small cap stock, international stock, emerging markets stock and real estate.  Setting an appropriate, well diversified asset allocation helps you balance risk and return within your portfolio.  Your asset allocation may change over time as your financial circumstances change.  However, avoid changing your allocation too frequently based on short term fluctuations in the market.

The appropriate allocation depends on several factors including your age and investment time horizon, your financial goals, other risk factors in your life, your experience with investing and your emotional risk tolerance.  Regardless of your investment goals, you need to maintain an emergency fund of readily available funds equal to at least four months of expenses.

Your financial goals are a major determinant in setting your allocation.  Identify your major financial goals and when money is needed to support these goals.  Design an asset allocation to meet these goals.  Money needed in the short term should be held in safer, interest earning investments. The stock market should only be used for long term needs – generally at least five to seven years out.

You may be able to assume more risk in your portfolio if the timetable for your goals is flexible.  The timeframe for money to cover things like college education or your emergency fund may be firm but there may be some flexibility on when you take a major vacation, remodel your home or plan to retire.   Money needed for retirement is generally spent over twenty or thirty years.  You won’t need your entire nest egg on the first day.

Your allocation is also dependent on risks taken in other areas of your life.  For example, if you work in a volatile career with unpredictable earnings, own a small business or own rental property, you may want to reduce the risk in your investment portfolio. On the other hand, if you have a secure job and anticipate a generous pension, you may be comfortable taking more risk.

Regardless of your situation you need to feel emotionally comfortable with your allocation. If you are constantly worried about market fluctuations you may need a more conservative allocation.   Historically the stock market has trended upward, but there will be years with negative returns.  Create an allocation that gives you adequate emotional security to ride out swings in the stock market and helps you avoid selling when the market is down. If you are new to investing, start out slowly and test the water to see how you will react in a volatile market.

Risk and Your Investment Portfolio – Part 1

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Deciding upon an asset allocation is one of the first and most significant decisions to be made when you start investing.  Your asset allocation is the percentage of different types of investments such as cash, bonds, stock or real estate that make up your investment portfolio.  Probably one of the most important allocations is that between investments in the stock market and investments in interest earning vehicles such as bank accounts, CDs and bonds.  An ideal asset allocation provides a balance between risk and return that helps you meet your goals but doesn’t keep you awake at night.

There is a trade-off between risk and return.  Generally, if you want a higher return you need to assume a higher level of risk.  Investment risk comes in many different forms with the most common being stock market risk.  Historically, over long periods of time, the stock market has out-performed most other investments.  However, in the short term it can be extremely volatile, including years with negative returns.  In the extreme case you could lose your entire investment in an individual stock.  To reduce risk in the stock portion of your portfolio, consider buying diversified stock mutual funds. You will still experience swings in the market but fluctuations in any one stock will have less impact.

On the other hand, interest earning investments such as bank accounts, CDs, bonds and bond funds are generally less risky and are not subject to stock market fluctuations.  Unfortunately, in exchange for this lower level of risk you may earn a much lower rate of return.

Additionally, bonds and bond funds are subject to interest rate risk and default risk.  If you purchase a bond or bond fund and interest rates increase, the value of your investment will decrease.  To make matters worse, when interest rates rise bond funds commonly experience a flood of redemptions forcing them to sell bonds within the fund at a loss.  Even if you hold on to your shares you can experience a drop in value. However, if you purchase an individual bond and hold it till maturity you will receive the full value upon redemption.   Use caution when buying low quality bonds or bond funds; you may get a higher return but you are subject to a much greater risk of default.

Many investors don’t consider inflation risk.  This results from taking too little risk with a conservative portfolio containing little or no stock.  Over time inflation has averaged about 3% annually, if you are only earning 2% on your portfolio your real return after inflation will be negative.  This is compounded if inflation rates rise significantly.  Consider increasing your allocation in the stock market to hedge against inflation risk.

In the current environment of low interest rates and high volatility it’s crucial to build a portfolio that balances risk and return to support your financial goals and provide you with peace of mind.

Avoiding the Stock Market Can be a Risky

Jane Young, CFP, EA

Jane Young, CFP, EA

You may be hesitant to invest in the stock market because it feels too risky.  However, consider the risk you are taking with your financial future by avoiding the stock market.  The primary reason to invest in the stock market is the potential for a much higher return, especially in low interest rate environments.  Most of us need the potential for long term growth provided by the stock market to meet our retirement needs.  If you invest all of your money in fixed income you may struggle just to keep up with inflation and you run the risk of outliving your money.

Historically, stock market returns have been almost double those earned by bonds.  According to the Ibbotson SBBI (stock, bonds, bills and inflation) report, between 1926 and 2014 the average annual return on Small Stock was 12.3%, Large Stock was 10.1%, Government Bonds was 5.5%, Treasury Bills was 3.5% and Inflation was 3%.  This illustrates that investing at least some of your portfolio in stock can provide a much greater opportunity than fixed income to meet your financial goals.

Investing in the stock market is not without risk.  As with all investments, we must take on greater risk to earn a greater return.  However, there are many ways to help manage the volatility of the stock market.  Before investing in stocks make sure your financial affairs are in order.  Pay off your credit cards, establish an emergency fund and put money that will be needed over the next five years into less volatile fixed income investments.  The stock market is for long term investing.  It can provide the opportunity to earn higher long term returns but you can count on some volatility along the way.  By creating a buffer to cover short term needs you will be less likely overreact to fluctuations in the market and sell when the market is down.

You can also buffer stock market risk by creating a well-diversified portfolio comprised of mutual funds invested in stocks or bonds from a variety of different size companies, different industries and a variety of different geographies.  Investing in a single company can be very risky but investment in mutual funds can reduce this risk.  When investing in mutual funds your money is combined with that of other investors and invested, by a professional manager, into a large number of stocks or bonds.  Investing in a large number of companies enables you to spread out your risk.

Dollar cost averaging, where you automatically invest a set amount on a regular basis – usually monthly or quarterly, can also reduce risk.  Rather than investing a large amount all at once, when the market may be high, you gradually invest over time.  With dollar cost averaging you buy more shares when the market is low and fewer shares when the market is high.

Selecting the Right Asset Allocation

Jane Young, CFP, EA

Jane Young, CFP, EA

When investing money, one of the first decisions to be made is your asset allocation.  Asset allocation is the division of your assets into different types of investments such as stock mutual funds, bonds, real estate or cash.  In order to maximize the return on your portfolio it’s crucial to maintain a well-diversified asset allocation.  According to many financial experts, asset allocation may be your single most important investment decision, more important than the specific investments or funds that you select.

There is no one size fits all; the right asset allocation is based on your unique situation which may change as your circumstances or perspective changes.  Some major factors to consider include investment time horizon, the need for liquidity, risk tolerance, risks taken in other areas of your life and how much risk is required to achieve your goals.

Arriving at the appropriate asset allocation is largely a balance between risk and return.  If you want or need a higher return you will have to assume a higher level of risk.  If you have a long investment time horizon, you can take on more risk because you don’t need your money right away and you can ride out fluctuations in the market.  However, if you have a short time horizon you should minimize your risk so your money will be readily available.

If you want to minimize risk, invest in fixed income investments such as money market accounts, certificate of deposits, high quality bonds or short term bond funds.   If you are willing to take on more risk, with the expectation of getting higher returns, consider stock mutual funds.  Generally, avoid investing money needed in the next five years into the stock market.   However, the stock market is an excellent option for long term money.

Regardless of your situation, the best allocation is usually a combination of fixed income and stock mutual funds.  With a diversified portfolio you can take advantage of higher returns found in the stock market while buffering your risk and meeting short term needs with fixed income investments.

Once your target asset allocation is set, rebalance on annual basis to stay on target.   Rebalancing will automatically result in selling investments that are high and buying investments that are low.  Avoid changing your target allocation based on emotional reactions to short term market fluctuations.    Stick to your plan unless there are major changes in your circumstances.

If you are unsure where to start, a good rule of thumb is to subtract your age from 120 to arrive at the percentage you should invest in stock market.  In the past it was customary to subtract from 100 but this has increased as life expectancies and the time one spends in retirement have increased.   In the final analysis, select an asset allocation that meets your specific needs and gives you peace of mind.

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