Download Week12.1 Asset Allocation - B-K

Personal Finance
Asset Allocation
Bill Klinger
Personal Finance
• Review
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Asset classes
Returns
Stocks
Bonds
Mutual funds
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Modern Portfolio Theory
Diversification
Load vs no-load
Managed vs index
Asset Allocation
• What percent of your money should be in each asset
class?
For example:
• 70% stock, 25% bonds, 5% cash, or
• 30% stock, 65% bonds, 5% cash
• The answer depends upon:
– Your investment objective
– Your tolerance for risk
Investment Objectives
Possible objectives:
• Must you have the money without a loss?
• Do you want to generate current income?
• Do you want the money to grow over a long time?
Risk
• How much risk can you tolerate?
– Can you stomach a 30% loss? A 50% loss?
• One of investors’ biggest risks is themselves.
– Risk of “Greed and Fear”
– End up buying high and
selling low – the worst
possible strategy
“Typical” Portfolio Allocations
Stocks
Bonds
Cash
Conservative
20%
55%
25%
Moderately
Conservative
40%
50%
10%
Moderate
60%
35%
5%
Moderately
Aggressive
70%
25%
5%
Aggressive
80%
15%
5%
Asset Allocation
• Cash
– ~3 months of expenses
• Stocks
Rule of thumb
%stocks = 100 – your age
• Bonds
Rule of thumb
%bond = your age
Where We Stand
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You have determined your:
1. Investment objective
2. Risk tolerance
3. Asset allocation
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Now - what investments
do you buy in each
asset class?
Investing
• Exercise
Efficient Markets Hypothesis
• Markets prices reflect all known information
• You can not beat the market consistently without luck
– Advisors may be correct, just not consistently
– Advisors love to talk about winners but not losers
– Survi
• What to do?
– Go with the market
– Invest in broad market index funds
– Less than 3% of actively managed funds beat index funds
over last 20 years*
* “Index Funds Win Again,” NY Times, Feb. 22, 2009.
Which Stocks and Bonds?
• Do not pick individual stocks or bonds
– Do you know more than the pros?
– Placing a bet
– Think of the person on the other side of a trade as an evil genius.
They’re probably not evil, but they are very smart.
Which Stocks and Bonds?
• Buy index mutual funds
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Pooling of investors’ money to buy investments
Diversifies your risk
Invest in broad market index funds
Less than 3% of actively managed funds beat index funds over
last 20 years*
– Legg Mason example
* “Index Funds Win Again,” NY Times, Feb. 22, 2009.
Index Funds
• A fund is a pool of securities that allow investors
to buy a share of many securities
• Many index funds available for stocks and bonds
Vanguard
Index 500
Total Stock Market Index
Total Int’l Stock Index
Total World Stock Index
Long Term Bond Index
Target Retirement 2050
Target Retirement 2055
Fidelity
500 Index
Total Market Index
International Index
U.S. Bond Index
Schwab
S&P 500 Index
Total Stock Market Index
International Index
Market Portfolio
In Practice
• Could add other asset classes
– Foreign stocks
– Foreign bonds
– Real estate
• REITS – Real estate investment trusts
• Also use index funds for other asset classes
• Don’t invest like a millionaire until you are one
But You Want More
• Not happy with getting what everyone else gets?
• More potential return means more real risk
• NOT ALL RISK IS REWARDED
– Think you can beat the pros?
– Some will win, others will lose
– Beware greed (remember Madoff?)
• Take risk knowingly, intelligently
Post-Modern Portfolio Theory
• Divide your portfolio into two parts
• Alpha
– Percentage of your portfolio that you are willing to “bet”
– Can be individual stocks or bonds, or funds
• Beta
– Percentage of your portfolio to invest in the market
– Invest according to your asset allocation
– Use index funds for asset classes
Post Modern Portfolio Theory
• Decide how big a bet you want to place
– What percent of your assets
– Called “alpha”
• Investment approach
– In the market, “beta”
– Place your bets, “alpha”
Investment Steps
1. Set aside a cash reserve
2. With the base of your investments (beta)
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2.
Determine your asset allocation according to your risk
tolerance (rule of thumb?)
Purchase asset classes using broad index funds
or target date funds
3. Decide how much you wish to bet (alpha)
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Place your bet and have fun
Managing Your Investments
• One of your biggest risks is you.
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Risk of “Greed and Fear”
When stock market goes up, people buy
When stock market goes down, people sell
The worst possible strategy
Many horror stories from 2008
• Have a strategy and stay with it
– “buy and hold”
Summary
• Think alpha + beta
• Do not fight the market, buy index funds
• Recognize your bets. There is a reason they are called
“bets”
Example
• Your investment objective
– You want to save for retirement
• Your risk tolerance
– You can take some risk but do not want to lose a lot
• Your alpha
– You believe Asian stocks will beat the market
– Willing to bet 10% of your money
Example – Your Investments
• Alpha
– Buy Asian index fund with 10% of your money
• Beta
– Asset allocation with moderate risk
– 60% stocks
• Purchase a total stock market index fund
– 35% bonds
• Purchase total bond market index fund
– 5% cash
• Purchase a money market fund
The Mechanics
• You can open accounts online
• www.vanguard.com
– Click on “Go to the site” and “Open an account”
• www.fidelity.com
– Click on “Open An Account”
• www.schwab.com
– Click on “Open an Account”
• Walk into a bank, e.g. PNC
Summary
1.
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Know your risk tolerance
Allocate ~3 months of expenses to cash
Identify your alpha and beta
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4.
Determine your investment objective
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5.
Short vs long term
Growth vs income
Determines asset allocation
Invest Beta according to asset allocation
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6.
Alpha – percent you are willing to bet
Beta – percent invested in the market
Use index funds to match the market or use target date fund
Place your bets with your Alpha
Years to “Financial Freedom”
Source: http://blogs-images.forbes.com/robertberger/files/2015/03/
Financial-Freedom-Calculator-1940x773.png
One Last Thought
Saving is the most important part of accumulating
wealth.
In Class
• In groups of two
– Kelsey is 25 and has $50,000 in savings. Her annual expenses
are $12,000. She would like to set aside 3 months of expenses
for emergencies. She also wants to keep $2,000 liquid for a
future purchase. The remainder of the savings Kelsey wants to
set aside for retirement. Kelsey thinks that Amazon can’t lose as
a company and is willing to bet 3% of her retirement investments
that it will do well. She is willing to take some risk to have the
rest of her money grow over time. How do recommend Kelsey
invest her savings?