The Financial Survival Guide to Retirement Investment Theory

Review Asset allocation is the single biggest determinate of portfolio results Major asset classes – Stocks – Bonds, – Cash How you allocate your investments depends upon the returns you need and risk you can take Rule-of-thumb: %stock = age

Where We Stand You have determined your: 1.Investment objective 2.Risk tolerance 3.Asset allocation Now - what investments do you buy in each asset class?

Financial Planner Exercise Who is the best financial planner in class?

Modern Portfolio Theory Asset class investments tend to move together – correlation – For example, in a recession But investments do not always move together – For example, high oil prices are good for oil companies but bad for airlines – Bad quality may affect only one company Diversifying your investments, can increase your average return and lower your risk!

Not All Risk is the Same Firm Risk = Systemic risk + Idiosyncratic Risk Business Cycles Financial Markets Global Conditions Risk Unique to the Firm Source of Correlation Idiosyncratic risk can be diversified away!

Diversification – Simple Example IBM and AT&T When IBM went down, AT&T went up. When AT&T went down, IBM went up. Not always. Maybe we should add more or different stocks. With large portfolio, 30 – 200 stocks, idiosyncratic moves cancel out!

Adding Investments Can Reduce Risk

Risk and Diversification Note: adding some stock to a 100% Treasury portfolio increases the return and decreases the risk!

Modern Portfolio Theory Optimal portfolios are a combination of the risk free asset and a market portfolio. Implications – Buy a money market fund (~risk free) – Buy an index fund (the market) – Asset allocation is determined by your risk tolerance Big Question – what is the market?

Modern Portfolio Theory

Foreign Diversification

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 – Survivorship bias 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.

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 Vanguard Index 500 Total Stock Market Index Total Int’l Stock Index Total World Stock Index Long Term Bond Index Fidelity 500 Index Total Market Index International Index U.S. Bond Index Schwab S&P 500 Index Total Stock Market Index International Index

Target Date Funds “Index” Funds whose asset allocation becomes more conservative over time Percent of stocks goes down, bonds go up Issue – What happens after target date? – You still have many years to go – Retirees face inflation risk, do not want to be too conservative – What does fund do after target date?

Building Your Market Portfolio Scott Burns' Lazy Portfolios Coach Potato Portfolio: - 50% in Vanguard Total Stock Market Index Fund (VTSMX) - 50% in Vanguard Inflation Protected Securities Fund (VIPSX) Margarita Portfolio: % in Vanguard Total Stock Market Index Fund (VTSMX) % in Vanguard Inflation Protected Securities Fund (VIPSX) % in Vanguard Total International Stock Index Fund (VGTSX) Four Square Portfolio: - 25% in Vanguard Total Stock Market Index Fund (VTSMX) - 25% in Vanguard Inflation Protected Securities Fund (VIPSX) - 25% in Vanguard Total International Stock Index Fund (VGTSX) - 25% in Vanguard REIT Index (VGSIX)

Building Your Market Portfolio Five Fold Portfolio: - 20% in Vanguard Total Stock Market Index Fund (VTSMX) - 20% in Vanguard Inflation Protected Securities Fund (VIPSX) - 20% in Vanguard Total International Stock Index Fund (VGTSX) - 20% in Vanguard REIT Index (VGSIX) - 20% in American Century International Bond Fund (BEGBX) Six Ways From Sunday Portfolio: % in Vanguard Total Stock Market Index Fund (VTSMX) % in Vanguard Inflation Protected Securities Fund (VIPSX) % in Vanguard Total International Stock Index Fund (VGTSX) % in Vanguard REIT Index (VGSIX) % in American Century International Bond Fund (BEGBX) % in Vanguard Energy (VGENX)

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 Any investment other than the market is a bet Bets are zero-sum propositions Can you beat the pros?

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

Example Your investment objective – You want to save for retirement Your risk tolerance – You can take some risk but want to be able to sleep at night 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

1-23 Twelve Financial Truths Jonathon Clements, WSJ 6/18/06 1.It’s hard to cut back 2.You will never be satisfied 3.Borrowings have to be repaid 4.Fancy cars and expensive clothes are not a sign of wealth 5.Your family could prove to be your greatest liability 6.Investors face three enemies 1.Inflation 2.Taxes 3.Investment costs

1-24 Twelve Financial Truths Jonathon Clements, WSJ 6/18/06 7.Adding investments can lower risk 8.Diversification is a mixed bag 9.Not all risk is rewarded 10.Most investors fail to beat the market 11.Change is costly 12.Your best investment strategy is saving

Summary 1.Determine your investment objective 2.Know your risk tolerance 3.Identify your alpha and beta Alpha – percent you are willing to bet Beta – percent invested in the market 4.Place your bets with your Alpha 5.Invest Beta according to asset allocation Use index funds to match the market

Homework What investment theory do you believe? How will that guide your investing? Do you have an investment strategy?