All About Asset Allocation 2nd Edition

By RICHARD A. FERRI

McGraw-Hill

Copyright © 2010 The McGraw-Hill Companies, Inc.
All right reserved.
ISBN: 978-0-07-170078-8

Contents

Chapter One

Planning for Investment Success

KEY CONCEPTS

• Investment planning is critical to long-term success.

• Asset allocation is the key element of investment planning.

• Discipline and commitment to a strategy are needed.

• There are no shortcuts to achieving financial security.

A successful lifelong investment experience hinges on three critical steps: the development of a prudent investment plan, the full implementation of that plan, and the discipline to maintain the plan in good times and bad. If you create a good plan and follow it, your probability of financial freedom increases exponentially.

An investment plan provides the road map to fair and equitable investment results over the long term. Your asset allocation decision is the most important step in investment planning. This is the amount of money you commit to each of various asset classes, such as stocks, bonds, real estate, and cash. It is your asset allocation that largely determines the growth path of your money and level of portfolio risk in the long run. Exactly how you invest in each of these asset classes is of lesser importance than owning the asset classes themselves, although some ways are better and less expensive than others.

What is you current investment policy? Consider the following two portfolio management strategies. Which one best describes you today?

• Plan A. Buy investments that I expect will perform well over the next few years. If an investment performs poorly or the prospects change, switch to another investment or go to cash and wait for a better opportunity.

• Plan B. Buy and hold different types of investments in a diversified portfolio regardless of their near-term prospects. If an investment performs poorly, buy more of that investment to put my portfolio back in balance.

If you are like most investors, Plan A looks familiar. People tend to put their money into investments that they believe will lead to profitable results in the near term and sell those that do not perform. The goal of Plan A is to “do well,” which is not a quantifiable financial goal. What does “do well” mean? Plan A provides no guidelines for what to buy or when to buy it, or when to sell because of poor performance or changing prospects. Academic research shows that people who trade their accounts based on near-term performance tend to sell investments that eventually perform better than the new investment they buy.

I have talked with thousands of individual investors about their portfolios over the years. It is interesting to ask people what their investment plan has been and if their returns have met their expectations. Most people will say that they have some type of invest plan, and they will say that their performance is generally in line with the markets, but both these statements are wishful thinking. An analysis of their portfolio often shows little evidence that any plan actually exists or has ever existed and that their investment performance tends to be several percentage points below what they guessed it might have been. The sad truth is that a majority of investors choose their stocks, bonds, and mutual funds randomly with little consideration for how they all fit together or the amount they pay in fees, commissions, and other expenses.

CHARACTERISTICS OF A PLAN

Successful investing is a three-step process: (1) plan creation, (2) implementation, and (3) maintenance. It is an important step forward for people to recognize that they need a good investment plan and good investments in the plan to meet their long-term financial objectives. Once people come to that realization, they need a method for creating their plan, which is where this book comes in. Second, then they need to implement the plan, because a good plan not implemented is no plan at all. Finally and most important is a process for maintaining the plan, because discipline drives long-term results.

A good plan has long legs and should last several years without major modifications. Annual reviews and adjustments are appropriate, with major changes occurring when something has changed in your life. Adjustments to plans should never be made in reaction to poor market conditions or be based on a comment some talking head made on television. You would not quit your job and change occupations because you are going through a slump nor should you change your investment plan because your portfolio is suffering in a bear market. These off periods are natural and expected, and you must learn to live with them.

Put your investment plan in writing, because a written plan is not soon forgotten. Your investment policy statement (IPS) should include your financial needs, investment goals, asset allocation, description of investment choices, and why you believe this plan should get you to your goals over time. I guarantee that you will not be making many snap investment decisions if you have the discipline to read your IPS before you make any change. All the planning in the world will not help if a plan is not implemented and religiously maintained. Most investment plans never become fully implemented because of a host of excuses including procrastination, distractions, laziness, lack of commitment, and the never-ending search for a perfect plan. I estimate that less than 50 percent of investment plans written are actually fully put into place. But that is not the whole story. Regular maintenance is the key to success following plan implementation. Markets are dynamic, and so is your portfolio. Periodic maintenance is needed to ensure that a portfolio is kept in line with the plan.

It is likely that less than 10 percent of all investment plans are fully implemented and maintained long enough and with enough discipline to make them work efficiently. Perhaps you may think I am being pessimistic, but that is what I have witnessed in my many years in the investment business. Many great investment plans fall by the wayside each year. There are a lot of good intentions out there, but there is much more procrastination.

THERE ARE NO SHORTCUTS

Money and life are intertwined in our culture. Our financial well-being is always on our minds. Will we have enough money? Will our children have enough for college? Is my income secure? What will happen to Social Security? Will I be able to afford health care? Are taxes going up? Will I be able to sell my house at the price I want when that time comes? Will I have to borrow money? What is my credit score? Most working people struggle to cover their living expenses let alone save enough for future obligations including retirement. They question when or whether they will be able to retire, and if they do retire, whether they will have a lifestyle that makes them comfortable. In the final years of life, decisions must be made about who gets our unspent money, how they get the money, and who is going to execute our estate. Money management is a never-ending battle from the time we get our first paycheck until we end our stay on this great planet.

Money matters are stressful, and investment decisions are part of that stress. When we save a little money, we don’t want to lose it by investing poorly. Yet we do want a respectable rate of return. The earlier in life a person learns to invest money, the better off that person will be both financially and emotionally.

Unfortunately, proper investing principles are not taught to the general public. There are no required courses on investing in high schools or trade schools or as part of a required curriculum at colleges, law schools, or medical schools. In addition employers do not require employees to educate themselves about investing their 401(k) or other retirement accounts. The government does not get between investors and their money unless there is fraud or misrepresentation involved. The public is all alone on financial education, and, unfortunately, that typically results in an expensive trial-and-error process.

Learning about investing through trial and error takes years of disappointments before you are able to discern good information from bad. It is very common for people to slip far behind the market averages during this learning period, and most people never make up the losses. When people realize that they have made investment mistakes and have fallen behind, they tend to compensate by becoming either overly conservative or overly aggressive. Both are bad. Once-burnt, twice-shy investors may not reach their financial goal if they do not formulate a plan that is aggressive enough to get there. Other people may become more aggressive in an attempt to get their money back quickly. The newspapers regularly print stories of people who decided to swing for the fences only to end up losing much more or being swindled by an unscrupulous advisor.

When young people make investing mistakes, they are not too damaging because these people typically have little in the pot and they have years of work and savings ahead. However, when an older person makes the same mistake, it can be devastating. The papers are full of sad stories about retirees’ life savings being wiped out because they put all their eggs in one basket and lost, or perhaps they were taken by the likes of a Bernie Madoff.

Enron Corporation was a highly publicized corporate bankruptcy that resulted from accounting fraud that ruined the financial lives of many people nearing retirement age. You could not pick up a newspaper or popular magazine without seeing an article about a former Enron employee who lost nearly all his or her savings as a result of the company’s collapse. Some former Enron workers considered selling their homes just to pay bills. Others were so devastated by the event that they did not know what would become of them. The stories typically included photographs of the victims depicted in a state of despair. Did the people in this country learn from Enron? No. Over the next decade, thousands of bankruptcies and near bankruptcies claimed the retirement savings of hundreds of thousands of rank and file employees who believed in those companies by purchasing their bonds. Some of those companies are household names, including General Motors, Lehman Brothers, AIG, Bear Stearns, and Chrysler. Will these bankruptcies of too-big-to-fail companies teach others to diversify their investments and lower their portfolio risk using asset allocation? Not likely.

WHY PROFESSIONAL ADVICE DOES NOT ALWAYS HELP

How do you learn about investing and at the same time avoid costly mistakes? One way is to hire a professional investment consultant, if you are lucky enough to find a good one. Hiring an advisor is a hit-or-miss proposition. The range of experience and education in the investment advisor industry is very broad. There are many professionals who are committed to their profession and would be very helpful in setting up an investment plan. And then there are those, regrettably, who would do more harm than good.

The investment business pays an abnormally high salary. Earnings for the typical advisor are on par with a well-paid physician or attorney. However, unlike physicians and attorneys who are required to have years of education before seeing patients and clients, investment consultants hired by a large brokerage house can start managing clients’ money within a few months of deciding to get into the industry, and they can earn significant income in a couple of years if they are good salespeople.

The requirements for becoming a registered representative at a brokerage firm or an independent fee-only advisor are surprisingly low. You don’t need a degree in finance or have any college. All you need to do is be able to read and write English, be felony free, and pass a simple exam. It takes about as much time and effort to become registered as a broker or advisor as it does for a 16-year-old to get a driver’s license, with one exception—the 16-year-old must show competence when driving before getting to the license. Since the barrier of entry into the investment field is so low, it should not be surprising when the Wall Street Journal publishes a long list of brokers and advisors each week who have been disciplined by the regulatory authorities for gross negligence, misappropriation of client funds, and outright fraud.

I do not want to be too critical of the brokers and advisors in the investment industry because there are many outstanding people out there. The problem you have is separating the good from the bad. There is no easy shortcut to doing this. Even those with the best credentials have fallen. And it takes only one bad decision by an investment advisor to wipe out your entire life’s savings. Bernie Madoff’s former clients know that too well.

THE ASSETS IN ASSET ALLOCATION

At its core, asset allocation is about dividing your wealth into different places to reduce the risk of a large loss. One hundred years ago, that may have meant your burying some cash in Mason jars around the barn in addition to hiding money in your mattress and the cookie jar. If your house went up in flames, at least the buried Mason jar money would survive.

I am not advocating putting money in a mattress or in Mason jars as an asset allocation strategy. This book focuses on placing money in publicly available investments such as mutual funds and exchange-traded funds (ETFs), and how that fits in with other assets such as your home, other real estate, businesses, hard assets such as coins and art, restricted corporate stock and stock options, and any claim you have on employer pensions, Social Security, and an annuity income.

Figure 1-1 is an investment pyramid that divides investment into five parts. The pyramid is used to classify assets and illustrate differences in liquidity and discretion that you may or may not have with those assets.

Here are brief descriptions of the five levels:

1. Level one is the base of the pyramid. It is characterized by highly liquid cash and cash types of investments that are used for living expenses and emergencies. This money is typically in checking accounts, savings accounts, and money market funds. This cash is not part of your long-term investment allocation, and you should not be overly concerned that your rate of return is low. The amount to keep in cash varies with your circumstances. I recommend 3 to 4 months in cash if you are single, 6 to 12 months in cash if you have a family, and 24 months when you retire.

2. Level two covers liquid, long-term investments. These are discretionary investments, meaning that you choose how to invest this money. The choices for investments typically include mutual funds, exchange-traded funds, certificates of deposit, and bonds. The accounts that hold these investments typically include self-directed retirement accounts, employee savings accounts, personal savings accounts, and fixed and variable annuities that are still accumulating (i.e., have not been annuitized). These assets can typically be converted into cash within one week.

3. Level three covers less liquid long-term investments that are also discretionary. They include your home and other real properties, businesses, art and other collectibles, hedge funds, venture capital funds, and other limited partnerships. These investments are less liquid than level two securities. They may be converted to cash over time, but it could take weeks, months, or even years.

4. Level four tends to cover investments that you have little or no discretion over. These assets can include employer-restricted corporate stock and stock options, employer-managed pension plans, Social Security benefits, and annuities that are paying out. These assets have strict rules governing what the money can be invested in, who can take the money, and when.

5. Level five is somewhat out of sequence. It covers speculative capital. These are the trading accounts that some people use to “play” the market. Investments at this level can be characterized as price-trend bets that have a short holding period. A trade may last for a few days or a couple of years. Investments can include, but are not limited to, common stock, niche mutual funds and ETFs, gold and precious metals, commodity futures, and commodity funds. These investments are hit-or-miss price guessing propositions. Place your bet, and hope for the best.

All five levels are important to your asset allocation. Some levels you have complete control over, and some you have no control over. You have complete control over the discretionary investments in your personal accounts and some retirement accounts. You have no control over Social Security benefits, employer-defined benefit pension plan investments, and company-restricted stock.

(Continues…)

Excerpted from All About Asset Allocation 2nd Editionby RICHARD A. FERRI Copyright © 2010 by The McGraw-Hill Companies, Inc.. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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