Welcome to the ‘Understanding Retirement Planning & Investing’ series! If you’ve missed the first few posts be sure to check them out!
Knowing that I’m a financial advisor, I’ve come to learn that most people really don’t have the slightest clue as to what asset allocation means.
It’s quite common for people in their 20s or 30s to have an asset allocation that’s suited for somebody in their 60s or 70s (100% in cash – i.e. CDs or money market accounts) because they’re scared of what’s going on in our economy and they don’t want to lose any of their money.
Instead of the traditional investment approach of buying LOW and selling HIGH, most ignorant investors do the exact opposite!
The Average Joe falls victim to emotion and makes decisions based on FEAR and GREED. There is no doubt that mass media plays a large part in this, so it’s likely that the more you read the paper and the more you watch the news, the MORE likely you are to make irrational decisions based on FEAR.
To first understand Asset Allocation, we must learn what different assets types there are to invest in (particularly in regards to saving for retirement):
Once you have a firm grasp of understanding that there are only a certain number of things you can invest in when saving for retirement, the next step is understanding that your Asset Allocation ultimately determines your rate of return over time.
Research, through numerous studies, have shown that 91% of a person’s RETURN on investment is based on ASSET ALLOCATION.
Knowing our ignorance in this regard, most Americans’ initial reaction when choosing an investment option in their 401(k) or IRA is to look at MorningStar and find out which funds have their coveted 5-Star Rating.
Others may jump to Kiplinger to find out the hot mutual fund for 2012.
Some may simply look at the 1, 5, and 10-year return on a particular fund and make their investment decision solely based on that.
Unfortunately this method of choosing investments gives you no real understanding of why you own a particular stock or mutual fund; therefore you really have no reason to hold onto it which causes you to sell it when things don’t go well and look for the ‘the next best thing’.
I mentioned at the start of the post that it’s extremely common to see somebody in their 20s, 30s, or 40s to be invested extremely conservatively based on the fear that consistently gets pumped into our minds.
However, the people that “play it safe” are really hurting themselves in the long run. If conventional wisdom tells us to ‘buy low and sell high,’ and you do the exact opposite by trying to time the market via getting in when things are going well and getting out when things are going poorly, you’re likely to miss the majority of the gains the stock market is going to give you.
Furthermore, if you always keep your money “safe” then it’s highly unlikely you’ll outpace inflation and realistically (whether you realize it or not) you are losing money – well, you’re losing purchasing power.
While risk tolerance does need to be taken into consideration, some people simply need to be coached on how to properly invest. Being in my 20s, I understand that I’m not going to NEED my retirement investments for a long period of time and this tells me that I can take a little more risk than most people.
Here is a visual that I use to help people understand how their retirement investments should be allocated along the assets of Stocks, Bonds, and Cash:
At the base of the triangle you have Cash (i.e. Money market accounts, CDs, or other “safe money” investments). These types of investments really have little to no risk but they also have little to no reward.
Bonds are a little more risky because there is a chance of default but they tend to give you a higher return over time than the “safe money” counterparts.
Lastly, as we all know Stocks are the most risky, however they tend to give you the best chance for long-term growth.
Ultimately, your particular allocation (again, the percentage of money that should be tied to stocks, bonds, or cash) will ultimately be based on a few things:
1. Your Risk Tolerance
2. Your Goals and the Rate of Return You NEED to Earn to Get There
3. Your Time Horizon (i.e. how long do you have before you NEED the money?)
The greater return a person needs to get in order to achieve their goals, the MORE they should be weighted towards stocks (when I refer to stocks, I mean stock-based Mutual Funds).
The LONGER somebody has until they retire (or until they need the money), the MORE you should be weighted towards stocks. Maybe an allocation of 95% stocks, 5% bonds…or something along the lines of 80/20 (stocks/bonds).
However, as you near retirement, it’s wise to shift your asset allocation towards a more conservative approach and take on a more bond-based allocation. In the next lesson I’ll discuss the 3 phases of investing, in which your phase on investing ultimately determines your asset allocation.
Ultimately, how you break down investment choices SHOULD go in this order:
1. Determine Asset Allocation – which percentage of your money should be tied to stocks, bonds, and cash. This answer lies in the following questions:
2. Diversify – once you know you should be allocated 80/20, then you look to diversify the 80% tied to stocks and the 20% tied to bonds.
This could be a whole different lesson but there are a few choices of stocks you could look for:
Once you diversify your 80% stock allocation in the above categories, then you need to break up the 20% bonds:
3. Select the Mutual Funds – after you have a grasp of your Asset Allocation and your Diversification approach, THEN it’s time to check out your fund options and choose which funds will best suit you based on:
There is little doubt that MOST people don’t want to mess with this process, thus we end up with people that (1) try to time the market based on FEAR AND GREED, (2) don’t know what they own which further lends itself to buying and selling, and (3) end up with people that get “burnt” by the market and choose to stay invested in cash and therefore never outpace inflation.
If you need help choosing funds in your 401(k), then there is nothing wrong with paying a professional a few dollars to help walk you through the process. I am biased, because it’s what I do, but I think it’s definitely worth the money in the long run!
For those that are too cheap to pay somebody, or for those that don’t really want to do the leg-work themselves, I’ll discuss Target Date funds in an upcoming post.
The articles are written by personal finance enthusiasts (not certified professionals) based on their personal experience. What works for them may or may not work for you, and you should always consult a financial advisor before making important financial decisions.
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