FAQ: Asset Allocation II
Posted: Sun Feb 04, 2007 9:38 am
Link to original thread: FAQ: ASSET ALLOCATION II
From: vinod281 (Original Message) Sent: 1/31/2003 11:28 AM
Just thought I can group some of the more common questions on asset allocation that have not been addressed in the prior post by RRK.
RRK, Desi, Vkrd, Therajs - Please correct any ommisions and add more if you like.
Q. The market appears to be high or is likely to go down during the next several months should I wait for it to go down before investing? Another way of asking this question is should I wait to increase my allocation to stocks?
A. Say you decide to wait 6 months and after 6 months
1. The market is higher: Do you wait longer for it to fall?
2. The market is at the same level: Do you wait longer for it to fall?
3. The market is lower: Would you wait for it to fall further?
Whatever happened you would not be able to bring yourself to invest after the six months. At every point of time the market is as likely to go up as down (atlest over the short term). This is due to the random nature of the stock markets, you cannot predict stock market direction. So the best course of action is to come up with an asset allocation plan and slowly dollar cost average to the desired allocation. Say your asset allocation plan calls for 60/40 stock/bond mix start off with 20/80 and over a one year period increase it to 60/40. This is for people who are starting with considerable amount of money ($10000 and above). If you have an amount lower than this I suggest to start off with your AAP (60/40 in the above case). Dont check your portfolio every day and stop watching financial news at the beginning days of your plan.
Q. How should I choose the stock/bond mix?
A. You should choose based on Need, Ability and Willingness to take risk. Although 50/50 and 60/40 are most common do not choose this just because that is what is advised by many planners.
Need - How much risk do you need to take? If a low rate of return meets your goal then lower is your need to take risk. This suggests a lower allocation to stocks.
Ability - The longer your investment horizon the greater your ability to take risk. The less important this goal is the greater your ability to take risk.
Willingness - At what risk level you cannot sleep well.
If you are either below 20% stocks or over 80% stocks get someone knowledgeable about finance to take a second look at your portfolio.
You should be mentally prepared to lose upto 50% of the stock value and still hold on to your asset allocation. If not reduce your allocation until you are comfortable with this.
Q. What is an Asset Allocation Plan? What does it contain?
A. AAP is your financial plan to meet your goals. It should specify what percentage of your portfolio should be in US stocks, International stocks and bonds. It should also contain your reason for choosing the percentages and also how it is going to very over time (80/20 at age 30 and 60/40 at age 50, etc). You should periodically (every 3-5 years) review this plan. But you should not be making drastic changes to the initial plan, unless something changed dramatically.
Q. I do not have any particular goal in mind, I just want to save and make as much money as possible what should my allocation be?
A. Here need is not well defined so the allocation should be based on Willingness and Ability as described above in "How should I choose the stock/bond mix?".
Q. Should I choose an actively managed fund or an Index fund? The manager of the actively managed fund beat the index over the last 10 years.
A. In several studies of mutual fund performance it has been repeatedly shown that past performance has no correlation with future performance. Lindner fund beat the market for 11 years in a row and then underperfomed the market by 6% over the next 17 years. Wheverever possible go with a broad based index fund.
Q. All the fund choices in my 401k are bad how should I choose between them?
A. Choose the fund with the lowest expense ratio after you decided what asset class is going into 401K. This is especially true for bond funds. Even an expense ratio difference of 0.2% would make a lot of difference over the long term.
See FAQ on asset allocation of how to fill up a 401k.
Q. I am very risk averse and cannot bring myself to invest in stocks but I know that I need to take some risk what can I do? or I lost money in stocks and could not bring myself to invest any more.
A. The best antidote to this is to learn more about finance and stock market from some of the books referenced in books to read section. There is nothing new in finance only history you did not know.
A few points to keep in mind
- Studies have shown that the more one trades the lower the returns.
- Dalbar study found that the average fund investor earned a cumulative return of just 141% from 1984 through 2000. That was a period when Standard and Poor's 500-stock index returned 1,201%. On an annualized basis, the S&P 500 returned 16%, but the average investor earned only 5%. That's pretty pitiful when you consider that money market funds earned an annualized 6% over those same 17 years. During the same period, the average bond fund investor made just 2.3% a year, compared with 5.8% for U.S. Treasury bills. Market timers beware.
- Asset allocation accounts for more than 90% of the returns.
Vinod
From: vinod281 (Original Message) Sent: 1/31/2003 11:28 AM
Just thought I can group some of the more common questions on asset allocation that have not been addressed in the prior post by RRK.
RRK, Desi, Vkrd, Therajs - Please correct any ommisions and add more if you like.
Q. The market appears to be high or is likely to go down during the next several months should I wait for it to go down before investing? Another way of asking this question is should I wait to increase my allocation to stocks?
A. Say you decide to wait 6 months and after 6 months
1. The market is higher: Do you wait longer for it to fall?
2. The market is at the same level: Do you wait longer for it to fall?
3. The market is lower: Would you wait for it to fall further?
Whatever happened you would not be able to bring yourself to invest after the six months. At every point of time the market is as likely to go up as down (atlest over the short term). This is due to the random nature of the stock markets, you cannot predict stock market direction. So the best course of action is to come up with an asset allocation plan and slowly dollar cost average to the desired allocation. Say your asset allocation plan calls for 60/40 stock/bond mix start off with 20/80 and over a one year period increase it to 60/40. This is for people who are starting with considerable amount of money ($10000 and above). If you have an amount lower than this I suggest to start off with your AAP (60/40 in the above case). Dont check your portfolio every day and stop watching financial news at the beginning days of your plan.
Q. How should I choose the stock/bond mix?
A. You should choose based on Need, Ability and Willingness to take risk. Although 50/50 and 60/40 are most common do not choose this just because that is what is advised by many planners.
Need - How much risk do you need to take? If a low rate of return meets your goal then lower is your need to take risk. This suggests a lower allocation to stocks.
Ability - The longer your investment horizon the greater your ability to take risk. The less important this goal is the greater your ability to take risk.
Willingness - At what risk level you cannot sleep well.
If you are either below 20% stocks or over 80% stocks get someone knowledgeable about finance to take a second look at your portfolio.
You should be mentally prepared to lose upto 50% of the stock value and still hold on to your asset allocation. If not reduce your allocation until you are comfortable with this.
Q. What is an Asset Allocation Plan? What does it contain?
A. AAP is your financial plan to meet your goals. It should specify what percentage of your portfolio should be in US stocks, International stocks and bonds. It should also contain your reason for choosing the percentages and also how it is going to very over time (80/20 at age 30 and 60/40 at age 50, etc). You should periodically (every 3-5 years) review this plan. But you should not be making drastic changes to the initial plan, unless something changed dramatically.
Q. I do not have any particular goal in mind, I just want to save and make as much money as possible what should my allocation be?
A. Here need is not well defined so the allocation should be based on Willingness and Ability as described above in "How should I choose the stock/bond mix?".
Q. Should I choose an actively managed fund or an Index fund? The manager of the actively managed fund beat the index over the last 10 years.
A. In several studies of mutual fund performance it has been repeatedly shown that past performance has no correlation with future performance. Lindner fund beat the market for 11 years in a row and then underperfomed the market by 6% over the next 17 years. Wheverever possible go with a broad based index fund.
Q. All the fund choices in my 401k are bad how should I choose between them?
A. Choose the fund with the lowest expense ratio after you decided what asset class is going into 401K. This is especially true for bond funds. Even an expense ratio difference of 0.2% would make a lot of difference over the long term.
See FAQ on asset allocation of how to fill up a 401k.
Q. I am very risk averse and cannot bring myself to invest in stocks but I know that I need to take some risk what can I do? or I lost money in stocks and could not bring myself to invest any more.
A. The best antidote to this is to learn more about finance and stock market from some of the books referenced in books to read section. There is nothing new in finance only history you did not know.
A few points to keep in mind
- Studies have shown that the more one trades the lower the returns.
- Dalbar study found that the average fund investor earned a cumulative return of just 141% from 1984 through 2000. That was a period when Standard and Poor's 500-stock index returned 1,201%. On an annualized basis, the S&P 500 returned 16%, but the average investor earned only 5%. That's pretty pitiful when you consider that money market funds earned an annualized 6% over those same 17 years. During the same period, the average bond fund investor made just 2.3% a year, compared with 5.8% for U.S. Treasury bills. Market timers beware.
- Asset allocation accounts for more than 90% of the returns.
Vinod