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
FAQ: Asset Allocation II
FAQ: Asset Allocation II
From: RRK Sent: 1/31/2003 1:41 PM
Vinod,
Good work ! I strongly encourage you to write long posts like this.
While it identified many items left out in earlier thread, it also answered many questions in many investors mind today.
** RRK
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From: vinod281 Sent: 1/31/2003 2:03 PM
Thanks RRK. I am copying your response to rebalancing into this post. I am also adding my comments below.
Q. What is rebalancing and why should I do it?
A. When you are selling stocks or buying stocks you do it by direction of AAP and balancing. Say you have decided your allocation to be 50/50 and later, the stock price goes up and your AA looks like 55/45, now is the time to sell. You dont look at individual stock price or NAZDAQ index numbers and decide to sell.
Same way, if stocks loose ground and your AA goes to 45/55, now is the time to buy.
This buy/sell signal comes from AAP and Only from AAP.
Some do AAP balancing at every 6 months and some do it for every 12 months. Some at tax time. I recommend Larry S rule for balancing.
- (1) change in 5% of total value or
- (2) 25% change in that asset class
which ever is earlier.
Let me give an example Say you decided 50/50.
Assume Stocks again broken up into
LB = 20, Intl = 20, Small Value=10
Now if Large Blend (LB) changes from 20% to 25% time to rebalance. Satisfy rule 1&2.
If small value increase from 10% to 12.5%, time to balance, satsify rule 2. ( no need to wait for 10% to become 15% )
Rebalancing brings your allocation back to your risk tolerance level and there is a possibility that you can increase your overall returns slightly. However this is not without risks. If stocks continually decline for a long period of time (Japanese investors from 1989 onwards) you would be losing money over this time, bacause you are moving money from your bond investments to stock. One alternative strategy is to balance it one way only from stock to bond but not the other way around. Based on historical evidence I would not recommend this however.
Vinod
Vinod,
Good work ! I strongly encourage you to write long posts like this.
While it identified many items left out in earlier thread, it also answered many questions in many investors mind today.
** RRK
------------
From: vinod281 Sent: 1/31/2003 2:03 PM
Thanks RRK. I am copying your response to rebalancing into this post. I am also adding my comments below.
Q. What is rebalancing and why should I do it?
A. When you are selling stocks or buying stocks you do it by direction of AAP and balancing. Say you have decided your allocation to be 50/50 and later, the stock price goes up and your AA looks like 55/45, now is the time to sell. You dont look at individual stock price or NAZDAQ index numbers and decide to sell.
Same way, if stocks loose ground and your AA goes to 45/55, now is the time to buy.
This buy/sell signal comes from AAP and Only from AAP.
Some do AAP balancing at every 6 months and some do it for every 12 months. Some at tax time. I recommend Larry S rule for balancing.
- (1) change in 5% of total value or
- (2) 25% change in that asset class
which ever is earlier.
Let me give an example Say you decided 50/50.
Assume Stocks again broken up into
LB = 20, Intl = 20, Small Value=10
Now if Large Blend (LB) changes from 20% to 25% time to rebalance. Satisfy rule 1&2.
If small value increase from 10% to 12.5%, time to balance, satsify rule 2. ( no need to wait for 10% to become 15% )
Rebalancing brings your allocation back to your risk tolerance level and there is a possibility that you can increase your overall returns slightly. However this is not without risks. If stocks continually decline for a long period of time (Japanese investors from 1989 onwards) you would be losing money over this time, bacause you are moving money from your bond investments to stock. One alternative strategy is to balance it one way only from stock to bond but not the other way around. Based on historical evidence I would not recommend this however.
Vinod
FAQ: Asset Allocation II
From: vkrd Sent: 1/31/2003 2:26 PM
Another excellent post Vinod. Keep up the good work. You have posted a link about index bond funds in India on a different thread. This along with other market Index funds / ETFs it seems AAP should become a bit easier in India.
vkrd
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From: ragu Sent: 1/31/2003 8:57 PM
Vinod & RRK;
Thanks a lot for this informative post.
ragu
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From: chicken_m Sent: 1/31/2003 9:03 PM
Excellent post:
You might have heard this thousand times. But having seen my parents' generation concentrating on real estate as their biggest asset, I can't resist but ask this.
Is real estate (other than primary residence) investment recomended? I am mostly looking at India real estate -- May be for future generation or for sale just like Stocks..
Another excellent post Vinod. Keep up the good work. You have posted a link about index bond funds in India on a different thread. This along with other market Index funds / ETFs it seems AAP should become a bit easier in India.
vkrd
---------------
From: ragu Sent: 1/31/2003 8:57 PM
Vinod & RRK;
Thanks a lot for this informative post.
ragu
--------------
From: chicken_m Sent: 1/31/2003 9:03 PM
Excellent post:
You might have heard this thousand times. But having seen my parents' generation concentrating on real estate as their biggest asset, I can't resist but ask this.
Is real estate (other than primary residence) investment recomended? I am mostly looking at India real estate -- May be for future generation or for sale just like Stocks..
FAQ: Asset Allocation II
From: vinod281 Sent: 2/1/2003 5:04 AM
Real estate is an excellent investment, especially in India if you understand the risks. Property laws take time to enfore in India and you need to be especially vigilant when renting. They are also very ill-liquid and returns are returns dominated by local factors. If you have someone very reliable to look after the property then IMO you might consider investing in real estate.
Vinod
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From: Desibabu19 Sent: 2/1/2003 8:08 AM
Vinod,
Great job.
To investors and young people starting out on the accumulation phase of their lives: Folks what you have here in this forum is very invaluable advice, while FP charlatans will try to steer you to actively managed load funds, and index funds may seem boring, your probability of performing better (compared to actively managed funds) with the approaches outlined in this forum is tremendous and it will free up some time for you to enjoy life as well as a bonus.
Identify your near term and long term goals.
Identify what you need to save - manage / modify current expenses accordingly
Exploit all current opportunities available such as ESPP, 401K match, FSA, DFSA etc.
Maintain emergency funds,
Have a prudent risk management plan (auto, home, health, life, disability insurance) - remember that insurance is supposed to be for catastrophic events that could financially cripple, not to protect against small risks. If you protect yourself against small risks, you will pay dearly (think about this when selecting deductibles).
Develop your AAP and stick to the plan.
Read the various threads in the forum. A lot of what I have written has been said before by many.
Desi
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From: KumSakthi97 Sent: 12/19/2004 4:50 PM
What does acronyms FSA and DFSA mean in #9.
Real estate is an excellent investment, especially in India if you understand the risks. Property laws take time to enfore in India and you need to be especially vigilant when renting. They are also very ill-liquid and returns are returns dominated by local factors. If you have someone very reliable to look after the property then IMO you might consider investing in real estate.
Vinod
------------
From: Desibabu19 Sent: 2/1/2003 8:08 AM
Vinod,
Great job.
To investors and young people starting out on the accumulation phase of their lives: Folks what you have here in this forum is very invaluable advice, while FP charlatans will try to steer you to actively managed load funds, and index funds may seem boring, your probability of performing better (compared to actively managed funds) with the approaches outlined in this forum is tremendous and it will free up some time for you to enjoy life as well as a bonus.
Identify your near term and long term goals.
Identify what you need to save - manage / modify current expenses accordingly
Exploit all current opportunities available such as ESPP, 401K match, FSA, DFSA etc.
Maintain emergency funds,
Have a prudent risk management plan (auto, home, health, life, disability insurance) - remember that insurance is supposed to be for catastrophic events that could financially cripple, not to protect against small risks. If you protect yourself against small risks, you will pay dearly (think about this when selecting deductibles).
Develop your AAP and stick to the plan.
Read the various threads in the forum. A lot of what I have written has been said before by many.
Desi
--------------
From: KumSakthi97 Sent: 12/19/2004 4:50 PM
What does acronyms FSA and DFSA mean in #9.
FAQ: Asset Allocation II
From: Desibabu19 Sent: 12/19/2004 6:12 PM
FSA = Flexible Spending Account
DFSA = Dependent Flexible Spendig Account
These are Tax exempt allocations for unreimbursed medical and dependent care expenses.
Desi
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From: MrSensible3497 Sent: 12/20/2004 12:23 PM
bagwan 6 (message #12),
Since a lot of our admins. are on vacation, let me humbly try to fill their shoes.
AAP is for your overall portfolio based on your age, risk profile and objectives. How much to split assets between India and U.S. depends on your R2I horizon and whether your return is "permanent", i.e. never to return back to U.S. A reasonable percentage of a serious R2Ier in his/her thirties is at least 50% assets be transferred to India. Remember, your asssets have to grow at a rate that beats Indian inflation, not U.S. inflation since your expenses are in India. However, U.S. is the largest, most dynamic and possibly the most productive economy in the world and may remain so for the considerable future. So, retaining some assets in U.S. (upto 50%) may be acceptable for the serious R2Ier. I would also recommend that you keep at least 10% of your equity portion invested in international stocks (non-US and non-India), to get overall country diversification. This may be accomplished by investing in international equity funds as a portion of your U.S. assets.
When you move to India, I would recommend you reduce the Indian equity exposure (unlike U.S.) because of additional risks in Indian capital markets. I have heard numbers of 10-30% equity in India with rest in fixed income investments for most R2Iers. This might be very different from your U.S. AAP (60:40 for eg.).
KRV
FSA = Flexible Spending Account
DFSA = Dependent Flexible Spendig Account
These are Tax exempt allocations for unreimbursed medical and dependent care expenses.
Desi
---------------
From: MrSensible3497 Sent: 12/20/2004 12:23 PM
bagwan 6 (message #12),
Since a lot of our admins. are on vacation, let me humbly try to fill their shoes.
AAP is for your overall portfolio based on your age, risk profile and objectives. How much to split assets between India and U.S. depends on your R2I horizon and whether your return is "permanent", i.e. never to return back to U.S. A reasonable percentage of a serious R2Ier in his/her thirties is at least 50% assets be transferred to India. Remember, your asssets have to grow at a rate that beats Indian inflation, not U.S. inflation since your expenses are in India. However, U.S. is the largest, most dynamic and possibly the most productive economy in the world and may remain so for the considerable future. So, retaining some assets in U.S. (upto 50%) may be acceptable for the serious R2Ier. I would also recommend that you keep at least 10% of your equity portion invested in international stocks (non-US and non-India), to get overall country diversification. This may be accomplished by investing in international equity funds as a portion of your U.S. assets.
When you move to India, I would recommend you reduce the Indian equity exposure (unlike U.S.) because of additional risks in Indian capital markets. I have heard numbers of 10-30% equity in India with rest in fixed income investments for most R2Iers. This might be very different from your U.S. AAP (60:40 for eg.).
KRV