All About ASSET ALLOCATION SECOND EDITIONRICHARD A. FERRI, CFANew York Chicago San Francisco Lisbon London Madrid M. All About Asset Allocation, Second Edition [Richard A. Ferri] on lacatanphydun.tk * FREE* shipping on qualifying offers. WHEN IT COMES TO INVESTING FOR. A clear and intuitive explanation for individual investors of the benefits of constructing an appropriate asset allocation and how to do so, this book can serve as.
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Asset allocation is one of the key ingredients allocation and the decisions your financial advisor makes regarding market funds are all considered short-. This books (All About Asset Allocation: The Easy Way to Get Started [PDF]) Made by Richard A. Ferri About Books none To Download Please. Asset allocation refers to the mix of investments inside your portfolio — how “ asset allocation” and “diversification” are often used interchangeably, not all.
Keep up the good work! Eric Ben commented on Feb 19 Eric, thanks for the comment. Sounds interesting. I do agree with you that a small cap and value tilt makes the most sense for long-term investors. I actually think that mid cap value is on of the most underutilized and forgotten asset classes of them all. Also agree with your assessment on fixed income. Take your risks with equities and use fixed income as your anchor. I think the barbaell approach of taking lots of risk in stocks and little risk in bonds is the way to go.
No need to get stuck in the middle where most investors get into trouble. HY should probably be considered part of the equity allocation considering the risk profile. To top it all off, a friend or family member was just hired by a brokerage firm, and you promised to listen to his or her novice sales ideas.
Procrastination has killed good intentions. Rebalancing is often the most difficult part of an asset allocation strategy because it is counterintuitive. Rebalancing requires you to sell a little of the investment that went up and download more of what went down. Can you imagine downloading stocks in early when the market was more than 60 percent below its high and every expert on television was predicting lower prices?
That is exactly what the strategy required, and the only investors who were rewarded with excess returns by the end of were those who rebalanced religiously. Introduction xi The temptations to deviate from a simple investment strategy are great. I know from my years of experience that many people are not able to stay the course.
There is a solution. If you do not have the discipline to manage an asset allocation strategy yourself, then hire a competent, low-fee advisor to do it.
You will pay for this service, but at least the job gets done fully and efficiently. I will tell you that it is not all about market risk. There is a lot going on in your life besides your investments. What happens outside your portfolio can affect how you react to your portfolio.
For example, if the markets are down, typically the economy is slow or slowing, which means that consumer confidence is low, and perhaps your job at risk. These outside influences create stresses in your life that may affect the way you invest your well-thought-out strategy. Your asset allocation should take into account potential stresses that may not seem to have direct impact on the asset allocation process. I spoke with one person in late who said she sold stocks at the bottom of the bear market.
Now she wanted to go back in at the same 60 percent stock allocation. My reaction was that she was investing above her tolerance for risk in and that going back in at a 60 percent in stock was a mistake.
It was my opinion that she would only make the same knee-jerk emotional mistake again during the next bear market. She insisted that she would not because last time she had just been through a messy divorce, her mother took ill and she had to move in to help, and her dog died. The loss of a job or any other loss can cause investors to abandon their investment policy even if the portfolio was set to the right risk level for the investors based only on their future financial needs.
A change in health can make people feel as though they have less control over their life, and this may cause them to overcompensate in an area they can control, such as changing their investment portfolio. One does not often think about job security, family matters, family health, and the amount of debt you owe as factors in an asset allocation decision, but they very important. In this second edition of All About Asset Allocation, I have enhanced the behavioral finance section.
There is also a new chapter on when to change an allocation and how to do it. The fundamental concepts written in this book provide a blueprint for the design, implementation, and maintenance of a prudent, reliable, lifelong investment plan. In some cases, the plan goes beyond the grave.
Read it, study it, create a plan, implement it, and maintain it. You will not be disappointed. I have been married to the same wonderful woman for most of my adult life, and I have also had the fortunate experience of getting to know many people over the decades by personally managing their investment portfolios.
This means asking about personal and some nonfinancial issues that may affect their outlook in the future. It is only with this understanding that my company can help guide an investor toward a prudent asset allocation. This process is by no means static.
It is an ongoing challenge. What I have learned over the years is that every investor has unique issues, and then we all have issues that are very similar. We all have liabilities that need to be paid for in the future, and we want to ensure there is enough money to meet those needs.
We are concerned about health care, taxes, educating our children and grandchildren, and then helping them later in life if needed. Most important, we do not want to outlive our own money and become a burden to our families. That is the biggest fear most people have about money. Introduction xiii What differs about how we view money is the amount we each need to cover future liabilities.
In other words, we differ in lifestyle. Different careers and opportunities lead us to different standards of living. What may be comfortable for one person may not be good enough for another.
Matching current assets and future income streams to those different liabilities is a challenge. This is where reasonable expectations, financial planning, and proper investment policy come in. It is typically a simple and concise document that it is easy for you to understand and follow. Some people write a policy for themselves, and other people go to a professional. The advisor may do a complete financial plan in an effort to find the investment policy that best fits your needs.
Everyone has different financial needs, different investment experiences, and different perceptions of risk. These differences make designing portfolios a multifaceted and challenging exercise.
Accordingly, the information in this book cannot cover every scenario, and the asset allocation examples in this book should be viewed as examples, not recommendations. There is no one-sizefits-all solution, especially when people are approaching their preretirement age. It will be up to you to grasp the important concepts that drive a successful asset allocation and then develop a portfolio mix to meet your special needs and circumstances. Over your lifetime, how you divide your investments among stocks, bonds, real estate, and other asset classes will explain almost all your portfolio risk and return providing you have the discipline to maintain your plan.
This makes the asset allocation decision one of the most important decisions in your life and is worth spending considerable time understanding.
At its root, asset allocation is a simple idea: diversify a portfolio across several unlike investments to reduce the risk of a large loss. Controlling risk through a prudent asset allocation plan and proper portfolio maintenance keeps you focused on the big picture during difficult periods in the market cycle, and this discipline is the key to your long-term investment success. One is a long-term strategy that is the focus of the book.
It does not require making short-term predictions about the markets in order to be successful. The other two require short-term market prediction in order to be successful. I leave those to the television talking heads.
Kathrein Dynamic Asset Allocation Fund
Strategic asset allocation no predictions needed 2. Tactical and dynamic asset allocation requires accurate market predictions 3. Market timing requires accurate market predictions This book is all about long-term strategic asset allocation. An asset allocation should not change based on the cyclical ups and downs of the economy or because some cynic publicly doubts the strategy and then personally benefits from investors who waver.
Tactical asset allocation is not the topic of this book, and this is the only place I address it. Tactical asset allocation assumes active changes to an investment mix based on short-term market forecasts for returns. These predictions may be a function of fundamental variables such as earnings or interest-rate forecasts, economic variables such as the outlook for economic growth in different countries, or technical variables such as recent price trends and charting patterns.
Market timing is tactical asset allocation in the extreme. It is an all-in or all-out decision on asset classes. For example, a market timer may start the year percent in stocks, change to 50 percent stocks and 50 percent in bonds sometime during year, and end with percent in cash.
Market timing is for people who believe they can consistently forecast major movements in the market and thus beat the market by trading. Introduction xv Tactical asset allocation and market timing sound like wonderful ideas, and they sure make a good sales pitch.
However, just about every unbiased academic study ever conducted shows that this type of asset allocation advice is no better than a flipping a coin.
The only reliable asset allocation strategy is the one discussed in this book. A well-balanced multi-asset-class portfolio that is maintained over time has the highest probability of success. All About Asset Allocation focuses on selecting the right assetclass mix for your needs, choosing low-cost investments that represent those asset classes, implementing the strategy, and maintaining it.
The facts and figures are presented in as straightforward a manner as possible. Some of the data are technical, so I have tried to illustrate these concepts with figures and explain their meaning in easy-tounderstand terms.
When you have finished reading all the chapters and you understand the important concepts in each chapter, you will possess the knowledge and the tools you will need to put together a sensible portfolio allocation that will serve you well for many years ahead.
All three are equally important. Accordingly, the best way to read this book is to start on the first page and read all the way through to the last. Part One explains the need for investment policy and the basic theory behind an asset allocation strategy. Chapter 1 explains why creating a viable investment plan is critical to success, and how asset allocation works in the plan. Chapter 2 is all about investment risk. Risk is defined in many different ways by many different people, ranging from losing money to the volatility of portfolio returns.
Chapter 3 covers the technical aspects of asset allocation based on a two-asset-class portfolio. It covers basic formulas and historical market relationships. Chapter 4 expands into multi-assetclass investing. Adding more asset classes to a portfolio can reduce risk and increase long-term return. Chapter 5 discusses the methodology used to segregate asset-class types and styles.
Chapter 6 looks at the U. Chapter 7 looks at international markets and how diversifying overseas helps U. Chapter 8 is an examination of the U.
Chapter 9 covers real estate investing, including home ownership. Chapter 10 is an explanation of alternative asset classes including commodities, hedge funds, precious metals, and collectibles.
All chapters provide a sample list of appropriate mutual funds and ETFs. By the time you have finished reading Part Two, you will have a comprehensive list of potential investments to consider.
Part Three is about managing your investment portfolio. Chapter 12 covers a life-cycle concept of investing and provides several examples of potential portfolios.
Chapter 13 is an interesting chapter on behavioral finance. The right asset allocation is the one that matches both your needs and your personality. Chapter 14 is new to this edition. It covers when it is appropriate to change your asset allocation and how to do it. Chapter 15 finishes up with a discussion of fees, taxes, index funds, and the pros and cons of hiring professional management.
The appendixes offer a wealth of extended information on asset allocation books and helpful investment Web sites. 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.
Consider the following two portfolio management strategies. Which one best describes you today? download 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. download and hold different types of investments in a diversified portfolio regardless of their near-term prospects. If an investment performs poorly, download 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.
Plan A provides no guidelines for what to download or when to download 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 download.
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.
It is an important step Planning for Investment Success 5 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.
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. Our financial wellbeing 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. 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 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-anderror process. Learning about investing through trial and error takes years of disappointments before you are able to discern good information Planning for Investment Success 7 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. 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. Level four tends to cover investments that you have little or no discretion over.
These assets can include employerrestricted corporate stock and stock options, employermanaged 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. Planning for Investment Success 11 5. Level five is somewhat out of sequence. It covers speculative capital. 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.
This begs the question: Will those nondiscretionary assets be there during your retirement? Or do you believe that the benefits from Social Security and employer pensions will be cut or perhaps eliminated in the future?
Only a portion of these benefits will transfer to a spouse upon your death, and basically none of it goes to your family with the exception of a small amount of Social Security benefits for your children while they are young. If you download an annuity with your retirement money, income will go to you and perhaps your spouse, but not to your heirs unless you take a lower payout. All these issues play an important part in your ultimate investment plan, and you will have to consider them in your asset allocation.
This strategy will reduce portfolio risk over time, and this leads to higher investment returns. This is attempted through self-management or by paying a professional advisor to pick investments. Neither works. Trying to consistently pick investments that are going to beat their benchmarks is like trying to win a marathon wearing muddy boots.
There is a lot of drag, and your odds of winning are very low. The high costs associated with attempting to beat the market will almost guarantee sluggish results.
In addition to high costs dragging down returns, a vast majority of investors, including professional money managers, do not have the needed information or skill to pick winning securities.
By law, all investors must get the same breaking economic and company financial news at the same time. This means that no one has an advantage. Watching CNN, Bloomberg Television, and other financial news networks will yield no useful information that will enable you to earn excess returns over the market.
That is insider trading. Just ask Martha Stewart. You could go to prison even if you receive no monetary benefit from passing someone else inside information. One famous case involved a Wall Street investment banker who past inside information to a prostitute in exchange for sexual favors. They both went to jail. Those people who can tell the difference are few and far between.
BEN CARLSON, CFA
Charlie Munger, the legendary investor and vice chairman of Berkshire Hathaway, explained to attendees at the annual shareholders meeting that Warren Buffett CEO of Berkshire Hathaway has been successful because he had a natural gift to sift through thousands of pieces of information and pick out the one or two items that had real market-moving relevance. He then said that the typical investor, including most professionals, spend too much time on irrelevant issues and miss the important things.
Planning for Investment Success 13 There are many people who claim that the markets are inefficient and that they can gain excess profits. However, it is not true for a vast majority of investors. For the mere mortals among us, the markets might as well be efficient because we are not Warren Buffett, and neither are the advisors we visit.
Consequently, we are not going to tap into the excess returns that may be available from time to time in an inefficient market. But this is more marketing than fact. The gurus talk only about their winners. There is no independent study that confirms skill among the television personalities. In truth, fads are difficult to forecast and more difficult to make money investing in. By the time you recognize something as a fad, the price of the stocks are already sky-high. Back in the early s, only a handful of people predicted that home computers would become a household appliance.
Who would have guessed that Microsoft Corporation would be one of the most successful companies in the twentieth century? When Microsoft was filing an initial public offering, Popular Science magazine was predicting that personal aero-cars would replace the family automobile by the twenty-first century. These carlike flying machines would take off and land in your driveway and eliminate all traffic jams.
Today, there are no aero-cars in driveways, but almost every household has at least one home computer, phone, game, or other electronic device running Microsoft software. Fad investing can be addictive—and costly. Many of the same people who suffered in the tech stock bubble and bust from to also suffered in the real estate boom and bust from to There are other fad traps that occurred recently.
China stocks are all the rage. Gold is the hot investment as I write this second edition in early We shall see. Unfortunately, uncovering the next star mutual fund manager is just as difficult as predicting the next fad.
Most people select mutual funds based on past performance. They use ratings put out by companies such as Morningstar, Inc. Cash flow studies show that a vast majority of new mutual fund contributions flow into funds that have recently received a 5-Star Morningstar rating for performance. The belief among investors is that these funds will outperform in the future.
That is not likely. downloading the Stars is not a reliable way to pick a winning fund. Five-Star ratings typically do not persist, especially when a rush of new money comes in and creates an insurmountable challenge to the fund manager to invest it. This typically means changing investment strategy, which is not what earned them the 5-Star rating.
Performance chasing is such a huge issue that the Securities and Exchange Commission mandates that every mutual fund advertisement clearly state that past performance is not an indication of future results. This is not possible. Every advisor who claims to have skill cannot be above average. It can be no other way. During congressional testimony concerning the economic crisis caused by the collapse of Long Term Capital Management, Federal Reserve Chairman Alan Greenspan cautioned against downloading into any new concept designed to outperform the markets.
House of Representatives: Planning for Investment Success 15 This decade is strewn with examples of bright people who thought they had built a better mousetrap that could consistently extract an abnormal return from financial markets.
Some succeed for a time. But while there may occasionally be misconfigurations among market prices that allow abnormal returns, they do not persist. Indeed, efforts to take advantage of such misalignments force prices into better alignment and are soon emulated by competitors, further narrowing, or eliminating, any gaps.
No matter how skillful the trading scheme, over the long haul, abnormal returns are sustained only through abnormal exposure to risk.
Even Warren Buffett took great risk early in his career by making large bets on a few investments that worked out. If he did not place big bets on a few companies in the s and s, he would not be wealthy today. Is this the way to do it? There are hundreds of thousands of would-be Warren Buffetts who were not so fortunate. Perhaps many of those people did have skill, but they got unlucky and their money ran out before their investments worked out.
We will never know who they are. Instead select an appropriate asset allocation and use low-cost index funds and ETFs to represent the markets you are investing in. Warren Buffett has publicly stated many times that index funds are the best way for most individuals to own commons stocks. Believe him. This approach is also extremely boring and slow. There are no home run investments to brag about and no exciting trading stories to tell.
Investment performance is not about what happened last week, last month, or last year. It is about what happens over a lifetime. You will have the best performance and the last word with an asset allocation strategy. Chances are that people will be coming to you for investment advice over the long term. The funny part about those future conversations will be when other people admit that they had no idea what they were doing, and you just smile.
Money is not a game. Investing for the rest of your life and the lives of your loved ones is serious business. The asset allocation strategy outlined in this book may not be a glamorous solution, but it does works. Learn the basics, create a viable investment policy, implement your plan, diligently follow the plan, and grind out investment gains as they come. With this no-nonsense, businesslike portfolio approach, you have the highest probability of reaching your financial long-term goals.
Sometimes boring is good. It will be based on your situation, your needs today and in the future, and your ability to stay the course during adverse market conditions. As your needs change, your allocation will also need adjustment. Monitoring and adjusting is an important part of the process.
Wall Street has tried very hard to commoditize the asset allocation process so that it can push through a lot of people in little time. Risk questionnaires are Planning for Investment Success 17 the by-product of this push. How you answer the questions will land your portfolio in a preselected box of investments.
Risk questionnaires may yield some useful information if the questions are worded well, but overall they are not the answer to the asset allocation question.
The questions typically address only one specific area: Even this question cannot possibly be determined by a computer model alone. The questionnaire approach probably works better on young investors who have a lot more in common with one other than people in their fifties and sixties.
These more established investors need a lot more attention in order to create a plan that reflects their unique situation. It requires soul-searching. We tend to be brave in a bull market, and this means that it is not the ideal time to search for our risk tolerance. Soul-searching should be done in a bear market when we are not sure what is going to happen next. Our Changing Needs As your financial needs change, your attitude toward investing changes, and accordingly, the asset allocation of your portfolio will need to be adjusted to accommodate changes in your life.
The following paragraphs touch on some of those issues and adjustments that occur during life. In this second edition you will find several passages that cover these topics in more detail.
Young investors should have at the core a savings plan. Learning to save is more important than learning to invest at this stage in life. A young person will likely try different investment strategies and lose money on most of them.
But this is the time to experiment. Young investors have the luxury of time on their side. Mistakes are not large, because these investors have little money in the game and plenty of time to make up losses. As time passes, youthful dreams are gradually replaced by midlife realities. By midlife, people tend to have a good idea of their career potential and what their long-term earnings stream will be like.
For the first time, people can envision how they might live in retirement and how they might refine their savings and investment plan to reach that goal. Investors in their late fifties and early sixties are typically in their peak earning years and are starting to actively prepare for some form of retirement. Children are finished with school or close to it, and they hopefully have found jobs and started careers. During this time, people refocus their energy on those aspects of their personal lives that have been neglected while they were raising a family and plan to do what makes them happy; for many folks this means working less or not at all.
By this time people should have accumulated enough retirement assets to be able to forecast a realistic retirement date, and their asset allocation should be reviewed and perhaps revised so that they can glide smoothly into the next stage of life.
Life is not forever. Portfolios tend to change as people enter their senior years. Investment decisions at this point may look beyond the grave. When people realize that they have enough money for the remainder of their life, they may consider investing a portion of the excess according to the needs and ages of their heirs. Ironically, this could mean that a portfolio becomes more aggressive than the one held currently.
Asset allocation is at the center of portfolio management in every phase of life. Asset allocation is personal. There is an appropriate allocation for your needs at every stage in life. Your mission is to find it.
Each asset class can be further divided into categories. For example, Planning for Investment Success 19 stocks can be categorized into U. Bonds can be categorized into taxable bonds and tax-free bonds. Real estate investments can be divided into owner-occupied residential real estate, rental residential real estate, and commercial properties.
The subcategories can be further divided into investment styles and sectors. Examples of styles include growth and value stocks, large and small stocks, and investment-grade bonds and non-investment-grade bonds. Sectors can be of different types. Stocks can be divided by industry sectors, such as industrial stocks, technology stocks, bank stocks, and so on; or they can be geographically divided, such as Pacific Rim and European stocks.
Bonds can be divided by issuer, such as mortgages, corporate bonds, and Treasury bonds. A well-diversified portfolio may hold several asset classes, categories, styles, and sectors. Successful investors study all asset classes and their various components in order to understand the differences among them. They estimate the long-term expectations of risk and return, and they study how the returns on one asset class may move in relation to other classes.
Then they weigh the advantages and disadvantages of including each investment in their portfolio. The tax efficiency may also be a consideration if the investment is going in a taxable account. Investors should be aware of which asset class, styles, and sectors are better placed in a taxadvantaged account such as a retirement account and which ones are suitable for taxable accounts.
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. They say that investors should be more in tune with what is happening in the markets today and make asset allocation adjustments as necessary.
The academics do not agree. Randolph Hood, and Gilbert Beebower, who looked at the same question 15 years earlier. In , the three analyzed the returns of 91 large U. Brinson, Beebower, and Brian Singer published a follow-up study in and essentially confirmed the results of their first paper: All About Asset Allocation is a written to help you decide the important 90 percent: Academics have done a good job of quantifying the benefits of asset allocation.
There are literally hundreds of papers on the subject, each one complete with an abundance of formulas, equations, acronyms, and industry jargon. I use some of these terms and formulas in an understandable way throughout the book. The concepts are explained as they are introduced. A glossary is provided at the end of the book if you come upon an term you are unsure of.
First, people should select an asset allocation mix that is best for their needs. Second, they should select individual investments that best represent those asset classes. The selection of investments to represent asset classes takes a lot of time because there are thousands of investments to choose from. I try to make the investment selection easy in this book. In general, you are looking for investments that have broad asset class representation and low fees. Index mutual funds and ETFs are a perfect fit for this purpose.
They give you broad diversification within an asset class at a reasonable cost. However, you need to be very selective in the funds you download. There are vast differences in cost and strategy even among index funds and ETFs. One fund may be managed identically to another except that the fees are significantly higher.
Another fund may say it tracks a stock market index, but that index is not a traditional market benchmark, and it does not move with the markets. Another consideration when selecting a fund is how the fund is managed. You can select a passive fund in which the manager attempts to match the performance of a benchmark index that follows a market, or an actively managed fund in which the manager is trying to beat a particular market.
I am not an advocate of using actively managed funds. On average, actively managed funds are much more expensive than passive funds, and rarely do active managers have enough skill to overcome the fees and commissions charged. It is also important to note that the data from market indexes are the backbone for study and design of asset allocation strategies.
This makes index funds and ETFs that follow these benchmarks an excellent choice for a portfolio. Their low cost, broad diversification, low tracking error with the markets, and high tax efficiency make these index funds and ETFs ideally suited to an asset allocation strategy. Several of these funds are highlighted at the end of each chapter in Part Two.
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 gets done.
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. Asset allocation is a central part of that plan. The strategy shifts the focus of investing from trying to pick winning investments to being diversified in many unlike investments at all times. Planning for Investment Success 23 No one knows what will happen in the financial markets next week, next month, or next year.
Yet we need to invest for the future. Asset allocation solves a problem that all investors face, namely, how to manage investments without knowing the future. Asset allocation eliminates the need to predict the near-term future direction of the financial markets and eliminates the risk of being in the wrong market at the wrong time. It also eliminates the risk of others giving you bad advice. We have only a finite amount of time in life to build a portfolio that will sustain us during retirement, and it does not take many mistakes before this goal is put in jeopardy.
You do not want to be the next person we read about in the newspapers who has lost his retirement savings by taking inappropriate risk or following the advice of the wrong advisor. Develop a good asset allocation plan, implement the plan, maintain the plan, and make adjustments as your needs change. Asset allocation is not an exciting investment strategy, but when it comes to making money, boring can be very profitable.
House of Representatives, October 1, Ibbotson and Paul D. Brinson, L.
Randolph Hood, and Gilbert L. Brinson, Brian D. Singer, and Gilbert L. There are no risk-free investments after taxes and inflation. Practitioners view risk as investment volatility. Individuals view risk as losing money. One of the oldest axioms on Wall Street is that there is no free lunch.
You do not get something for nothing.
The Rick Ferri 60/40 Portfolio
Investors who take no investment risk should expect no return after adjusting for inflation and taxes. Unfortunately, taking investment risk also means that you can and will lose money at times. There is simply no way around this. There is no free lunch. The risk and return relationship of business is one of the few laws of economics that has stood the test of time throughout history. If people tell you otherwise, they are either selling snake oil or they are naive. There is a direct relationship between the amount of risk taken and the expected return on an investment.
People expect to earn a profit from stock and bond investments because they are taking a risk. Stocks pay a dividend from earnings, bonds pay interest, and real estate pays rents; however, those income streams are not certain. The greater the uncertainty that this income will materialize, the higher the expected return on the investment must be. The changing risk perception on an investment is adjusted by market price. All else being equal, when the risk goes up, prices go down, and when risk goes down, prices go up.
If the future cash flows of an investment such as a bond are known, investors who download at lower prices expect to make higher returns because the risk of not receiving that cash flow is higher at that time, and investors who download at higher prices expect to make lower returns because the perceived risk is lower at that time.
With bonds, the risks are inflation, interestrate increases, taxes, and a potential default by the issuer. Portfolio risk cannot be eliminated although it can be partially controlled with an asset allocation strategy. Combining different investment types, each with its own unique risk and return characteristics, into one portfolio creates a unique risk and return tradeoff in the portfolio.
This is similar to making bread from flour, yeast, and water. The combined product has different characteristic from its ingredients. This risk reduction phenomenon does not happen every year, but it does happen over several years if you are a disciplined investor. Once you grasp the mechanics behind asset allocation and accumulate information on different types of investments, you will be ready to design a portfolio that has an expected return and an acceptable level of risk for your needs.
Treasury bill T-bill , a government-guaranteed investment that matures in one year or less. The interest is the difference between the download price of the bill and its face value paid at maturity. The U. Treasury issues T-bills weekly, and the interest rate is set by an auction system. The current T-bill rate is a good proxy for the interest an investor will earn in a money market fund because T-bills are frequently downloadd in money market funds.
However, risk-free may be an inappropriate choice of words. T-bills do have a reliable positive return; however, that return is subject to the corrosive effects of taxes and inflation. Figure highlights the year-over-year T-bill return minus 25 percent income tax and the inflation rate.
There have been many years when the rate of return on T-bills has not kept pace with the inflation rate after taxes. Investors in T-bills and money market funds are losing downloading power in the years when the bar in Figure is below 0 percent. During these years, money invested in T-bills downloads fewer goods and services than it did one year earlier.
Taxes are a big drag on T-bill returns. For example, the nominal T-bill return in was 4. The after-tax return was 3. However, inflation was 4. The loss would have been greater for investors in higher-income tax brackets. The chart assumes that 25 percent federal income tax was paid each year on the return. The lowest point on Figure was in If you think about this, for more than 30 years we have been paying our government to borrow money from us.
There are a couple of Treasury investments that are protected from the corrosive effect of inflation but not taxes. The interest paid during the period also increases with the inflation rate. 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. Treasury Inflation Protected Securities Index fell by 2. 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.
BEN CARLSON, CFA
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. Academics often define risk as the volatility of price or return over a specified period.
Volatility can be measured in different ways and over different periods. You can use price highs or lows or closing prices. You can measure volatility daily, weekly, monthly, or annually.
High volatility means erratic investment returns, whereas low volatility means more consistent investment returns. Annual return volatility measurement tends to be the one most commonly used to compare asset class risk. My view of price volatility is somewhat different from that of the academics. Price and return volatility do not define risk. Rather, they are a derivative of some other risk factor.
With bonds, it is the wavering expectations of future inflation and interest rates. With commodities, price volatility is caused by changes in the supply and demand curve. For example, the volatility of commodities is about the same volatility as stocks. However, commodities pay no interest, have no earnings, and pay no dividends. Consequently, the expected return of commodities is lower than those of stocks even though the price volatility is similar. Pension fund trustees tend to view risk as the uncertainty that their employee pension obligations will be met in the future.
Definedbenefit pension plans are managed so that the future payments to retirees are matched by the future expected value of the pension fund.
An actuarial assumption of pension obligations is compared to a forecast plan value based on an estimated return on assets and future contributions. If the forecast plan value is equal to the obligation, the plan is fully funded and no excess contributions are needed from the employer. An underfunded pension obligation means that the employer will have to commit more resources to the plan to maintain its solvency, and this could cause financial difficulty for the employer. Mutual fund managers see risk as the underperformance of their fund compared to other fund managers with the same investment objective.
If a large growth fund manager does not perform well in relation to other large growth fund managers, then the fund will lose assets as investors liquidate shares, not to mention that the manager will likely lose his or her job.
Unlike academics, pension fund trustees, and money managers, individual investors define risk in a more direct way. They define it as losing money. It does not matter if a person made money for several years prior; it is the here and now that matters. Consider the year It was the year the stock market crashed. What was the return of the market that year? On Friday, October 16, stocks unexpectedly fell by 9 percent.
Understanding Investment Risk 31 The following Monday, known as Black Monday, prices came crashing down another 23 percent. Investors were shell-shocked. No investor who had money in a diversified stock portfolio for the entire year in lost money, but that is not what people remember. We only remember how bad it felt to lose money on Black Monday. Everyone wants to earn a fair return on his or her investments after inflation and taxes. This will require risk and probably losing money on occasion.
All the broadly diversified portfolios introduced in this book have inherent risk and will go down in value periodically. It would be nice to know when these losses will occur so that we can sell beforehand, but that is simply not possible. No one can predict with any consistency when the markets will go up or down. If a person tells you she has found the secret to the markets, she is either naive or she is trying to steal your money.
Either way, smile and walk. There is no free lunch on Wall Street, and the asset allocation strategies in this book do not provide a free lunch either. Proper asset allocation can reduce the probability of a large loss and perhaps the frequency of losing periods, but it is not a panacea for the elimination of portfolio risk.
You can and will have periods when your portfolio is down in value. This is also a good definition for individual investors to adopt. The thought conjures up images of living out your old age in miserable substandard housing and relying on government money for subsistence, or worse, relying on family charity.If he did not place big bets on a few companies in the s and s, he would not be wealthy today.
This makes index funds and ETFs that follow these benchmarks an excellent choice for a portfolio. Take your risks with equities and use fixed income as your anchor.
When using a calendar method, investors choose to rebalance after a specific period of time, such as a year, a quarter, or a month.
The students learn about correlation, risk reduction, and the efficient frontier in a simple model of two investments that have low correlation with each other. Taxes are a big drag on T-bill returns. Please verify that this file is suitable for Commons before transferring it. Pension fund trustees tend to view risk as the uncertainty that their employee pension obligations will be met in the future.
Between and , the correlation turned negative.
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