Personal Finance Asset Allocation Bill Klinger

Personal Finance Review Asset classes Returns Stocks Bonds Mutual funds Modern Portfolio Theory Diversification Load vs no-load Managed vs index

Asset Allocation What percent of your money should be in each asset class? For example: 70% stock, 25% bonds, 5% cash, or 30% stock, 65% bonds, 5% cash The answer depends upon: Your investment objective Your tolerance for risk

Investment Objectives Possible objectives: Must you have the money without a loss? Do you want to generate current income? Do you want the money to grow over a long time?

Risk How much risk can you tolerate? Can you stomach a 30% loss? A 50% loss? One of investors’ biggest risks is themselves. Risk of “Greed and Fear” End up buying high and selling low – the worst possible strategy

“Typical” Portfolio Allocations Stocks Bonds Cash Conservative 20% 55% 25% Moderately Conservative 40% 50% 10% Moderate 60% 35% 5% Moderately Aggressive 70% Aggressive 80% 15%

Asset Allocation Cash Stocks Bonds ~3 months of expenses Rule of thumb %stocks = 100 – your age Bonds %bond = your age

Where We Stand Investment objective Risk tolerance Asset allocation You have determined your: Investment objective Risk tolerance Asset allocation Now - what investments do you buy in each asset class?

Investing Exercise

Efficient Markets Hypothesis Markets prices reflect all known information You can not beat the market consistently without luck Advisors may be correct, just not consistently Advisors love to talk about winners but not losers Survi What to do? Go with the market Invest in broad market index funds Less than 3% of actively managed funds beat index funds over last 20 years* * “Index Funds Win Again,” NY Times, Feb. 22, 2009.

Which Stocks and Bonds? Do not pick individual stocks or bonds Do you know more than the pros? Placing a bet Think of the person on the other side of a trade as an evil genius. They’re probably not evil, but they are very smart.

Which Stocks and Bonds? Buy index mutual funds Pooling of investors’ money to buy investments Diversifies your risk Invest in broad market index funds Less than 3% of actively managed funds beat index funds over last 20 years* Legg Mason example * “Index Funds Win Again,” NY Times, Feb. 22, 2009.

Index Funds A fund is a pool of securities that allow investors to buy a share of many securities Many index funds available for stocks and bonds Fidelity 500 Index Total Market Index International Index U.S. Bond Index Vanguard Index 500 Total Stock Market Index Total Int’l Stock Index Total World Stock Index Long Term Bond Index Target Retirement 2050 Target Retirement 2055 Schwab S&P 500 Index Total Stock Market Index International Index

Market Portfolio In Practice Could add other asset classes Foreign stocks Foreign bonds Real estate REITS – Real estate investment trusts Also use index funds for other asset classes Don’t invest like a millionaire until you are one

But You Want More Not happy with getting what everyone else gets? More potential return means more real risk NOT ALL RISK IS REWARDED Think you can beat the pros? Some will win, others will lose Beware greed (remember Madoff?) Take risk knowingly, intelligently

Post-Modern Portfolio Theory Divide your portfolio into two parts Alpha Percentage of your portfolio that you are willing to “bet” Can be individual stocks or bonds, or funds Beta Percentage of your portfolio to invest in the market Invest according to your asset allocation Use index funds for asset classes

Post Modern Portfolio Theory Decide how big a bet you want to place What percent of your assets Called “alpha” Investment approach In the market, “beta” Place your bets, “alpha”

Investment Steps Set aside a cash reserve With the base of your investments (beta) Determine your asset allocation according to your risk tolerance (rule of thumb?) Purchase asset classes using broad index funds or target date funds Decide how much you wish to bet (alpha) Place your bet and have fun

Managing Your Investments One of your biggest risks is you. Risk of “Greed and Fear” When stock market goes up, people buy When stock market goes down, people sell The worst possible strategy Many horror stories from 2008 Have a strategy and stay with it “buy and hold”

Summary Think alpha + beta Do not fight the market, buy index funds Recognize your bets. There is a reason they are called “bets”

Example Your investment objective Your risk tolerance Your alpha You want to save for retirement Your risk tolerance You can take some risk but do not want to lose a lot Your alpha You believe Asian stocks will beat the market Willing to bet 10% of your money

Example – Your Investments Alpha Buy Asian index fund with 10% of your money Beta Asset allocation with moderate risk 60% stocks Purchase a total stock market index fund 35% bonds Purchase total bond market index fund 5% cash Purchase a money market fund

The Mechanics You can open accounts online www.vanguard.com Click on “Go to the site” and “Open an account” www.fidelity.com Click on “Open An Account” www.schwab.com Click on “Open an Account” Walk into a bank, e.g. PNC

Summary Know your risk tolerance Allocate ~3 months of expenses to cash Identify your alpha and beta Alpha – percent you are willing to bet Beta – percent invested in the market Determine your investment objective Short vs long term Growth vs income Determines asset allocation Invest Beta according to asset allocation Use index funds to match the market or use target date fund Place your bets with your Alpha

Years to “Financial Freedom” Source: http://blogs-images.forbes.com/robertberger/files/2015/03/ Financial-Freedom-Calculator-1940x773.png

One Last Thought Saving is the most important part of accumulating wealth.

In Class In groups of two Kelsey is 25 and has $50,000 in savings. Her annual expenses are $12,000. She would like to set aside 3 months of expenses for emergencies. She also wants to keep $2,000 liquid for a future purchase. The remainder of the savings Kelsey wants to set aside for retirement. Kelsey thinks that Amazon can’t lose as a company and is willing to bet 3% of her retirement investments that it will do well. She is willing to take some risk to have the rest of her money grow over time. How do recommend Kelsey invest her savings?