We have all heard the expression, ďDonít put all your eggs in one basket.Ē When it comes to investments, this same expression holds true.
What do we mean by diversify?
Most people think of diversification as putting money into different industry sectors. For example you may have some of your assets in technology stocks, some in financial services stocks, and some in oil stocks. This qualifies as one type of diversification, but there is another type of diversification which is based on the type
of investments you make. This type of diversification, called ďasset allocationĒ, is our topic for the month.
What do we mean by asset allocation.
Does this mean you are going to spend half of your life savings on a new Ferrari and the other half the house? We hope not. We hope it means, how you allocate your investments to make the most of your money, without driving you crazy.
There are a number of factors for you to look at when you start reviewing your investment portfolio. These are Ė Your age, your income, your needs, and how much risk you want to take. When you consider all of these factors together then you will ox a fairly decent idea of what type investments you should own.
Letís take a look at age.
If you are 21 and you plan on working until you are 70 years old. Then you have a pretty long time until retirement. All things being equal, this means you can stand to lose a little in the market now because you have time to earn enough to recoup your losses. This gives you the luxury of investing in more equity based investments (stocks and mutual funds that invest in stocks), which typically have more risk than fixed-income investments (bonds and mutual funds that invest in bonds) but also tend to have higher returns.
On the other hand, letís assume you are 61 and you plan on retiring at age 65. You have built up a pretty good nest egg, but the volatile market has you worried. You donít have the time a 21 year old would have to makeup losses, so you would probably want to invest more heavily in fixed income securities.
Now let's look at your income.
What kind of income are you making at now? What is your earning potential in the future? Couple this question with your current needs and how much you already have invested to find out what you should be doing with your money.
Say for instance you make a zillion dollars a month, you plan on doing the same for the rest of your working life, and, you already have enough cash socked away to take care of yourself for the rest of your life. As long as you donít spend that same zillion dollars plus another half-zillion on your monthly bills, chances are you will probably be safe investing in more risky assets since you will be able to make up any losses out of income. You also have more ďrisk capitalĒ because all of your basic needs are covered.
On the other hand, if you donít make all that much and you may need some money if the refrigerator breaks down, investing in risky assets may not be wise. You may need to beef up your rainy day savings account before you invest in something that has market risk.
Last let's look at how risk adverse you really are. If you are the Las Vegas gambler type, chances are the collective mood swings, and resulting roller coaster ride on Wall Street, wonít bother you too much. However, if your investing style to this point has been to save half your income in cans buried strategically in the back yard, a roller coaster is not what you should be riding. This may mean nice, safe, U.S. Treasury Bills are more your style.
If you add all the above up, plus what you think you will need for retirement, and, what you think will happen long term in the various investment markets, you have the beginnings of an investment allocation model tailored to your needs.
But this is just the beginning. How do you quantify the allocations? Here are a few general rules. At the end of the article, we will give you a couple of references to help you out.
If you are young (say less than 40) you should have time to recoup any investment losses before retirement. This assumes you have acted prudently in your investment decisions. In this case, an asset mix of 5% cash, 20% bonds and 75% stocks may be a good allocation model for you.
If you are in the prime of life and in your prime earning years (say 40-55), you probably still have time to add to the nest egg and will be able to withstand some market fluctuations. Still, you have a greater need to protect your retirement assets than a 21-year-old. In this case, an asset allocation of 5% cash, 35% bonds and 60% stocks would be appropriate for you.
Say you are just about to retire, or have retired. This should put you around 62-65years-old. First, we congratulate you on your newfound freedom. Second, you may wish to look at an allocation to better protect your future income. This means you probably want about 10% of your assets in cash, 45% in bonds and 45% in stocks. You may think of 45% of your assets being in stocks to be a little risky, but think about how much longer people are living today. You will probably want some higher earning assets to extend the life of your investments and maintain your quality of life.
Ok, you have now been retired five plus years and are over 70. You know the odds of living to a 100, while better than 50 years ago, are still not on your side. This may be an appropriate time for you to reallocate your assets again. Now, you would probably be looking at an asset allocation model somewhere around 15% cash, 60% bonds and 25% stocks. You never want to completely liquidate the higher earning assets simply because you may live to be 100 years old. Wouldnít it be a bummer if you had just enough assets to live to age 100, only to live to age 101?
The preceding allocation models are very general in nature and may not fit your own situation. Thatís why you should never make quick decisions and should always seek the advice of your investment professional and your CPA.
What are some of the possible pitfalls in changing your allocation model? One of the biggest, may be taxes. If you have 100% of your assets in equity securities that you bought 20 years ago, and the general rules above say you should only have 25% in stocks, selling 75% of your portfolio could create a huge tax liability.
Assume you have $1 million of Intel stock with a basis of $25,000. If the stock is outside of a qualified retirement plan, do you really want to pay $146,250 in taxes to meet a specified asset allocation mix? Maybe you do and maybe you donít. The answer lies in all the facts surrounding your current lifestyle and temperment.
We said we would offer some suggestions on places to go to look at asset allocation models. Two sites we use are Fidelity Investments
and Smart Money.com.
These are not the only sites on the Internet to offer some type of asset allocation programs, investment professional or mutual fund sponsor may also provide asset allocation information.
The recent fluctuations in the stock market should serve to remind us all that nothing is certain, not even a bull market. One of the best ways to protect ourselves is to allocate our investments among industries, and investment classes. Asset allocation models help us determine our best allocation strategies.
If you are thinking about changing the allocation of your assets, use the above information as only a guideline donít do it just because someone says your allocations amongst the various investment classes are wrong. Always seek the advice of your investment professional or give us a call before making any major asset decisions.