From Rick Ferri’s book “All about Asset Allocation”
Asset allocation is the most important decision investors can make for their portfolio.
- “Asset allocation is the cornerstone of a prudent investment plan and is the single most important decision that an investor will make in regard to a portfolio. Once the fundamentals of asset allocation are understood and all the various styles and sectors of each asset class have been examined, it is then time to select the best investments to represent those asset classes. Once investment selection is completed, the investment policy is ready to be put into action.” (p. 19)
- “Asset allocation is at the center of portfolio management in every phase of life. Younger investors will develop asset allocations from a perspective that’s different from that of older investors because they are different, but that does not mean that young investors will have a more aggressive allocation than older people. It depends on each person’s unique situation. Asset allocation is personal. There is an appropriate allocation for your needs at every stage in life. Your mission is to find it.” (p 18)
- “• A proper asset allocation is designed to match an investor’s needs. • The overall risk cannot be above one’s tolerance for risk. • The life-cycle method is a good place to start. • A modified version of “your age in bonds” is also helpful. A successful investment plan is one that is designed specifically for the person who intends to use it.” (p. 243)
- “While people’s asset allocations will be broadly similar in some ways, each person’s allocation will be uniquely different in others. This and the next two chapters offer guidance on designing an investment plan that is right for your needs.” (p. 243)
- “Your asset allocation will change several times as your circumstances and resources change over time. Investors’ ages tend to have a meaningful impact on asset allocation decisions, not so much because they are aging but because over a career people convert their labor into assets and then live off those assets in retirement. In addition, people of different ages have different financial wants and needs, and that correlates with different perceptions on investment risk.” (p. 244)
You can start with 4-5 funds or use up to 12 funds.
- The first portfolio is a simple allocation utilizing four or five low-cost mutual funds or ETFs. The second portfolio is a more advanced multi-asset-class portfolio utilizing between 9 and 12 low-cost mutual funds or ETFs. Either portfolio offers a good base from which to start—or end. You can begin with one of the portfolios and add or take away funds to suit your particular needs. You may want to limit the number of funds you have in your portfolio to 12 because after that you reach diminishing returns and higher costs.” (p. 246)
Midlife -Asset Allocation
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- During midlife, investors reach the halfway mark in their careers. It is a period when salaries are on the rise, and this means that the amount allocated to savings should also be increasing. It is a point in life where investors can see the future with more clarity and can use that vision to develop a strategic asset allocation that matches future retirement needs.
- At this stage, the cash savings set aside for living expenses and emergencies should be extended out to 12 months, if possible. A larger emergency fund will help cover those unanticipated needs that seem to occur all too often with growing families.
Speculative investments should not grow any larger then they have been during the early-saver years and probably should start to wind down. It is dangerous to think that you will find a way to make money by speculating at this point in your life if you did not make any money by speculating when you were young.
During midlife, long-term investment accounts are growing larger, and working years are growing shorter. A balanced asset allocation is appropriate. Figure 12-3 highlights the range of asset allocations that is typical for midlife accumulators. Like asset allocations for all groups, Figure 12-3 represents an either-or allocation, not a to-from allocation. Do not try to shift between stocks and bonds at what seem like appropriate times. No one can time the markets.
The median asset allocation for people in midlife is 60 percent in stocks and 40 percent in fixed income. Tables 12-3 and 12-4 give basic and multi-asset-class portfolios for midlife accumulators.
During midlife, people begin to reach higher levels of earnings, which may affect their investment choices. Taxes can play a considerable role in asset allocation. If a person’s income places him or her in an income tax bracket of 30 percent or more, that person should consider tax-free municipal bonds. The after-tax return from tax-free bonds will be higher than having taxable bonds and paying the taxes. More information on how taxes affect asset allocation can be found in Chapter 15.” (p. 256)
Transitional Retirees- Asset Allocation
- “Transitional retirement covers the period from preretirement though active retirement. A person typically enters the preretirement phase from three to five years before leaving full-time employment.
Preretirement is not a formal announcement of impending retirement; rather, it is a thought process. During this period, many people become perplexed about questions such as when to retire, whether they have enough money to retire, and what amount of money they can safely withdraw from savings so that they do not run out of money in retirement. It is probably the most conservative period in a person’s life.
Most people who are nearing retirement tend to be in their peak earning years and peak savings years. They are at or close to their highest level of career advancement and are earning top wages. On the home front, household expenses have stabilized and are possibly going down. Children are either self-sufficient or only a few years away from becoming self-sufficient. It is a nice time because you actually have money that is all yours.
The transition from full-time work to retirement signals a new investment phase in a portfolio. The portfolio will convert from accumulation to distribution. That means that investors will soon stop putting money in and start taking some out.
People who are closing in on a retirement date think and act in the most conservative manner of their lives during these transition years. They tend to shift their portfolios to the asset allocation that they will use during retirement. The shift does not happen overnight. Rather, it tends to be gradual as the retirement year approaches.
Brand-new retirees are uncertain about how their cash flow in retirement is going to work out or whether they have a good retirement plan. That causes some people to be very defensive with their asset allocation by reducing risky investments to a small percentage of their portfolio and by hoarding cash.
There is little reason to be overly conservative in a portfolio during the transition phase. Some extra cash in a short-term bond fund is appropriate because it helps the cash-flow jitters go away after about a year or two. I generally recommend at least one year and up to two years in living expenses in a cashlike account or short-term bond fund during retirement.
The tip-of-the-pyramid’s speculative investments should be avoided as you transition into retirement. If you have not made money speculating by now, you are not going to do it in retirement. Let the urge go. Now is the time to be businesslike with your wealth.” (p. 256)
Mature Retirees- Asset Allocation
- “The asset allocation of a mature retiree’s portfolio can vary depending on who is going to use the money. There should be two years of living expenses in cash and short-term bonds, and there should not be any tip-of-the-pyramid speculative investments. However, the allocation of the long-term liquid investments can vary considerably.
- On the one hand, a portfolio should be conservatively managed to carry a retiree through the remainder of his or her life. On the other hand, the allocation could favor the needs and ages of the beneficiaries if a retiree is not going to need all of his or her money. Generally, a portfolio is managed based on a combination of both scenarios. Figure 12-5 highlights suggested asset allocation for mature retirees.
- As in the other stages, the range of allocations presented in Figure 12-5 is three separate portfolios. Trying to time markets by moving between allocations is not a prudent strategy. Tables 12-7 and 12-8 give sample portfolios for investors in this stage. The asset allocation recommendations outlined in Tables 12-7 and 12-8 represent that portion of the portfolio that will be used by a mature retiree during his or her lifetime. More than likely, a majority of the assets are not going to be used by the retiree. Rather, they will be passed on to heirs. Therefore, a portion of the portfolio should be allocated based on the needs of those inheriting the assets.” (p. 266)
Withdrawal Rates in Retirement
- One question asked by most people in preretirement is how much they can safely withdraw from their portfolios without touching the principal. There have been several in-depth studies on this question, and they all point to about a 4 percent withdrawal rate.
However, there are many factors that need to be considered before you limit your rate to 4 percent or less. Several are:
• At what age are you retiring? Younger retirees should probably limit their withdrawal rate to 4 percent or less because they have a long time horizon. Older retirees can afford to have a higher withdrawal rate because their time horizon is shorter.
• How much do you want to leave behind when you are gone? Retirees who want to leave their children or other heirs as much as possible should withdraw less than those who do not wish to leave so much behind.
• How long do you believe you will be an “active” retiree? Everyone eventually slows down as a result of age or health. Spending during the mature retirement years is typically less than in the active retirement years. This means that it is okay if you spend a little more in your active years.
Cash for withdrawals can be produced in a portfolio in many ways. Interest and dividend income are two sources. There is also annual rebalancing in a portfolio. You can easily calculate the amount of income your investments will give you and then take any shortfall during a rebalancing.” (p. 260)
Make sure your investments are in the right tax efficient accounts.
- “Some investments are less tax-efficient than others. Corporate bond interest is taxed at a higher rate than stock dividend income. Short-term capital gains are taxed at a higher rate than long-term capital gains. Since different investments and different types of accounts are taxed differently, investors can reduce their annual tax burden by placing appropriate investments in the right accounts. Investments that distribute a high level of taxable income should be placed in tax-deferred or tax-free accounts, and investments with low-tax dividend distributions and long-term capital gains should be placed in taxable accounts.
- Examples of investments that you should consider placing in a tax-deferred or tax-free account include:
• Corporate bonds and bond funds
• Certificates of deposit, agency bonds, and mortgages
• Mutual funds that have a high turnover of securities
• REITs and REIT mutual funds
• Commodities funds - Examples of investments that you should consider placing in a taxable account include:
• Low-turnover equity funds, including equity index funds
• Broad market equity exchange-traded funds
• Municipal bonds and municipal bond funds - Saving on taxes is a good idea; however, nothing is as easy as it seems. Tax location strategies have side effects that may hinder investment strategy. Here are issues to consider:
• Tax location strategies make rebalancing difficult. Having different investments stretched across several accounts creates a rebalancing quagmire.
• Your personal tax rate is not consistent. The ideal tax location strategy today may not be the ideal strategy five years from now.
• Tax rates today are not likely to be the tax rates in the future. Any change may affect your strategy.” (p. 307)
Don’t overanalyze.
- “The information presented in this book will get you thinking deeply about how to optimize an asset allocation for your needs. That is exactly the intent of this book. You should spend some time thinking about how the strategy works before you design a portfolio and implement a plan. However, at some point you must finish your work and implement your decisions.
There can be a tendency to overanalyze market data in an attempt to find the ideal asset allocation. That is not a good idea. The ideal asset allocation can be known only in retrospect. You cannot know what it is today. Consequently, the quest to find the perfect plan becomes a never-ending undertaking. At some point you will hit analysis paralysis and nothing will get done. The Prussian General Karl von Clausewitz once said, “The greatest enemy of a good plan is the dream of a perfect plan.”
You can never know everything about every asset class, style, and sector. Even if you were to become very knowledgeable about asset classes and how they work together, you still could not know for certain how the portfolio will act in the future. You can only develop a portfolio that has a high probability of success, implement the portfolio as is, and maintain it. No portfolio guarantees success, but a plan never implemented is sure to fail.
Take the time to establish a prudent investment plan for your needs, implement that plan, and begin to maintain it. Putting a good plan into action today is much better than searching for a perfect plan that cannot be known in advance.” (p. 22) - “The enemy of a good plan is the quest for a perfect plan because the quest for a perfect plan is an endless journey. The minutiae bog people down. They start to suffer from analysis paralysis, and nothing gets accomplished. Fight the urge to be perfect. Instead, design a good plan, implement that plan, and maintain that plan. You will be much further ahead by doing so. The best portfolio you can design is one that fits your needs. If you are comfortable with the allocation, you will maintain it over a long period of time and during all market conditions. That is what really counts.” (p. 81)
T-bills
- “The lowest-risk investment in the U.S. financial markets is a U.S. Treasury bill (T-bill), a government-guaranteed investment that matures in one year or less. T-bills are sold at a discount from face value and don’t pay interest before maturity. The interest is the difference between the purchase price of the bill and its face value paid at maturity.” (p. 26)
TIPS
- “There are a couple of Treasury investments that are protected from the corrosive effect of inflation but not taxes. Treasury Inflation-Protected Securities (TIPS) and I-bonds are Treasury securities that protect principal and interest from rising inflation. The maturity value of these bonds increases in direct proportion to an increase in the inflation rate. The interest paid during the period also increases with the inflation rate.” (p. 28)
- “Some people argue that TIPS are a better representation of a risk-free rate than T-bills because inflation is factored out. But TIPS are not without their own risks. First, TIPS are publicly traded securities, and, as such, they fluctuate in value as interest rates rise and fall. The Barclays Capital U.S. Treasury Inflation Protected Securities Index fell by 2.4 percent in 2008 while the Consumer Price Index (CPI), a proxy for inflation, was up by 0.1 percent. Second, neither TIPS nor I-bonds escape taxation. Both the interest payments and the inflation adjustment gain are eventually taxed as ordinary interest income. More information on inflation-protected securities can be found in Chapter 8.
Risk-free investing is a myth. It does not exist. If there were a risk-free investment, it would have a federal government guarantee, stable pricing, and inflation protection, and the interest income would be free from all city, state, and federal income tax. That being said, if the government guarantees a bond, it must be AAA rated and stay AAA rated, which is a risk in itself. As of this writing, there is no such investment.” (p. 29_
Higher risk will give higher returns.
- “In the long run, all the investments selected for a well-diversified portfolio are expected to generate a certain rate of return given their inherent level of risk. We do not know what that rate of return will be, but we should expect investments with higher risk to generate returns greater than those with lower risk. If you did not expect a higher return from the higher-risk investment, then a logical person would not make that investment and the price would fall (see Chapter 11 for more about expected risks and returns of various asset classes).” (p. 44)
Rebalancing
- Diversifying across many investments that are dissimilar and rebalancing those investments to their original target at the end of the year can reduce the annual volatility of the portfolio over time by enough to increase the compounded return. This “free lunch” from rebalancing is the essence of modern portfolio theory. There are different methods of rebalancing. The two most popular are based on the calendar and percentage targets. When using a calendar method, investors choose to rebalance after a specific period of time, such as a year, a quarter, or a month. Other investors prefer to use asset class percentage targets. When a portfolio is off the target allocation by a certain percentage, it is rebalanced, regardless of when the last rebalancing took place. A rebalancing strategy based on percentages may deliver slightly better performance than the calendar method; however, the difference is not much. The percentage strategy requires significantly more time to monitor and implement, and I do not believe it is worthwhile for individual investors to pursue this strategy. Therefore, annual rebalancing is the method used in this book. What is best for you is one you will actually maintain without procrastination. Annual rebalancing is simple and cost effective, and it takes only a little time each year to implement, which means that you are more likely to get it done.” (p. 47)
Even broadly diversified portfolios will lose money.
- “There will be periods of time when even the most broadly diversified portfolios will lose money. When those periods occur, there is nothing an investor can do short of abandoning the entire investment plan, which is not a good idea. Trying to guess when down periods will occur and adjusting your portfolio accordingly will probably lose you more money and cause you more frustration than sticking with your plan and pushing through the storm.” (p. 62)
International funds should be in your portfolio.
- “I have the greatest respect for John Bogle, but I don’t always agree with him, and this was one of those times. A single 10-year period is not a reason to be out of international stocks for a lifetime. By the end of 2009, after international stocks outperformed U.S. stocks by a wide margin, people saw the benefits of international exposure. Even John Bogle changed his view and now accepts an allocation of up to 20 percent in international stock index funds. There have been and will be periods when international stocks reduce portfolio risk and increase return, and times when they do not. However, over a lifetime of investing, international equity is one way to add a diversification benefit over an all-U.S. stock allocation.” (p. 72)
More asset classes is better than a portfolio with fewer asset classes.
- “A portfolio with more asset classes is better than a portfolio with fewer asset classes, within limitations. Any diversification benefit tends to diminish after about 12 different investments, and the maintenance cost required increases.” (p. 81)
There are times where stocks don’t beat inflation
- “It is not always easy to earn a real return in the U.S. stock market. There have been several periods of time between 1950 and 2009 when U.S. equities did not perform well. For 15 years, from 1968 to 1982, the inflation-adjusted return of U.S. equities was barely above the rate of inflation. From 2000 to 2009, U.S. stocks lost 2.9 percent annually with an adjustment for inflation. This was the worst performance for a real return since the 1930s Depression.” (p. 103)
- “Stock investors should expect periods of time when equities do not make money after inflation. It is the nature of investment risk. This is also why time in the market is critical to stock investors. In the long run, equities have outpaced inflation by a wide margin, and they are expected to remain one of the best real return investments in the future. You have to stay invested during all market conditions to benefit from the gains.” (p. 103)
Other Good Quotes:
There are several ways to select a multi-asset-class portfolio. One way is to answer a few questions on a questionnaire and feed those answers into a computer. The problem with this approach is that the computer is purely mathematical and relies too much on past risks, returns, and correlations. Basically, the computer simulation assumes that whatever happened in past is the most probable scenario for the future. This is an extremely unreliable way to make investment decisions. The world is constantly changing, and no computer simulation can accurately predict the changes that will occur or how these changes will affect a portfolio. In addition, a computer does not know who you are and cannot assess your personality profile so that the allocation it recommends truly fits your needs. It does not know how secure your job is, or how healthy you are, or if you have special family needs. It does not know if your children have become financially independent or if your parents are still financially independent and will remain that way. No computer knows if Social Security is going to be around 25 years from now. A computer model may be mathematically correct based on the very limited facts it is fed, but the answer it produces is not going to work if the allocation does not fit who you are, what your circumstances are, and what you are trying to accomplish. I believe in a more thoughtful, subjective approach to asset allocation.
Ferri, Richard A.; Ferri, Richard A.. All About Asset Allocation, Second Edition (pp. 81-82). McGraw Hill LLC. Kindle Edition.
Correlations between investments can change sharply and without warning in an unpredictable world. You may think your portfolio is hedged, but it is not. There is no known way to design a portfolio that is fully hedged against market downturns while fully participating in market upturns. There is no free lunch on Wall Street.
Ferri, Richard A.; Ferri, Richard A.. All About Asset Allocation, Second Edition (p. 89). McGraw Hill LLC. Kindle Edition.
Commodities and precious metals are good examples of asset classes that historically have no real return. These asset classes are often touted as having occasional negative correlation with stocks and bonds which consequently lowers portfolio risk at times. However, there is no real return benefit from the money allocated to these investments over the long term.
Ferri, Richard A.; Ferri, Richard A.. All About Asset Allocation, Second Edition (p. 94). McGraw Hill LLC. Kindle Edition.