Kent E. Irwin is the President and Co-Founder of eFinplan, LLC, the first online comprehensive financial planning software for consumers. He is also a Chartered Financial Consultant (ChFC), a Chartered Advisor in Philanthropy (CAP) and a Chartered Life Underwriter (CLU).
There are three ways to invest money, and the most boring way works best for most people: Asset Allocation.
The other two ways to invest: market timing or picking stocks are more sexy. Next time investing comes up at a cocktail party you will be sure to hear someone touting their get rich quick hot stock. When interest rates soar, or stocks drop you may even hear someone brag about how they got in or out at just the right time, or used some type of ‘option’ strategy and made a bundle. You will see people interested in these types of conversations, because many people’s investment portfolios have not performed well.
Most people are not good at picking stocks, even with the internet and greater access to information than ever, there are too many stocks and too little information about each one – and it gets outdated quickly. People are emotional. Even if they pick good ones, they often sell them at the wrong time, because their fears overtake their ability to objectively make decisions.
Market timing always becomes popular when the stock market drops, and people see their account values dropping as they are now. No one has consistently shown the ability to predict markets or securities. To win you have to have 60% accuracy just to cover the losses caused by mistakes of the other 40% – because of transaction fees and taxes. You have to be correct in all four decisions: what/when to buy and when/what to sell.
You are sure to put a damper on a party conversation by mentioning ‘asset allocation.’
What is asset allocation? It is the method of investing based on the study by Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower in 1991. They found that over 91% of long-term portfolio performance is derived from the decisions made regarding asset allocation, and not market timing or security selection. This traditional buy and hold method is boring – but it works.
When you asset allocate you invest a portion of your money into each of the major asset classes: Cash, Bonds, and Stocks. When it comes to your stock portion you split or allocate it into Large Cap, Mid Cap, Small Cap and Foreign Stock.
If you are conservative you allocate a greater percentage into cash and bonds and large cap stock. If you are aggressive your allocation has less cash and bond and more mid, small and foreign stock. Aggressive allocations will probably have a better rate of return over time than going conservative, but will be the most volatile, meaning your values will fluctuate up and down more. You can pick a model like the ones below or take a quiz utilizing software to help identify your tolerance for handling risk.
I have designed 5 fictitious model portfolios to help demonstrate different risk levels. I call the most conservative the ‘Volvo portfolio’. The ‘Volvo portfolio’ fits you because you want something solid (good rate of return) and protection from market risk. The ‘Lexus portfolio’ is for those you are conservative but want more speed (little better rate of return), but you still like a smooth ride. The ‘Acura portfolio’ fits those who want a little more sport (higher rate of return), and are willing to encounter a little more risk. Riskier investors may choose the ‘BMW portfolio’, to get great performance (higher rate of return), and because they can tolerate tricky roads (a lot of market fluctuation). Lastly, the ‘Porsche is for those who want maximum performance, and whose nerves can tolerate the riskiest of roads. This fictitious demonstration was done with premium cars, because investing with asset allocation over the very long term will hopefully position you to be able to eventually afford one. In conclusion, neither of these asset allocation models would be considered at the upper end of the high risk continuum. As you progress from conservative to aggressive asset allocation models, you increase your probability for volatility and rate of return, but not by wide margins over the long term.
‘The Volvo’ – Very Conservative
Large Cap Stock 20
Mid Cap Stock 10
Small Cap Stock 5
Foreign Stock 5
‘The Lexus’ – Conservative
Large Cap Stock 25
Mid Cap Stock 12.5
Small Cap Stock 7.5
Foreign Stock 7.5
‘The Acura’ – Moderate
Large Cap Stock 30
Mid Cap Stock 10
Small Cap Stock 10
Foreign Stock 15
‘The BMW’ – Aggressive
Large Cap Stock 35
Mid Cap Stock 15
Small Cap Stock 12.5
Foreign Stock 15
‘The Porsche’ – Very Aggressive
Large Cap Stock 37.5
Mid Cap Stock 20
Small Cap Stock 15
Foreign Stock 17.5
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