Four Rules for Asset Allocation
May 25, 2010 by Jean Keener, CRPC, CFDP · Leave a Comment
As a special guest blog post, the Motley Fool staff has provided the following article on asset allocation. It’s an excellent summary of some of the most important concepts of investing and asset allocation, and is definitely worth the read. Enjoy!
By The Motley Fool
When it comes to asset allocation, the biggest decisions come down to how much you should have in cash, how much in bonds, and how much in stocks. These four rules for asset allocation will help you slice up your portfolio into these important pieces.
Rule 1: If you need the money in the next year, it should be in cash.
You don’t want the down payment for your vacation home to evaporate in a stock market — or bond market — crash. Keep it in a money market or savings account. And, of course, make sure it’s FDIC-insured.
Rule 2: If you need the money in the next one to five (or even seven) years, choose safe, income-producing investments such as Treasuries, certificates of deposit (CDs), or bonds.
Whether it’s your kid’s college money or the retirement income you’ll need in the not-so-distant future, stay away from stocks.
As with all investments, risk and reward go hand-in-hand when it comes to “safe” assets. So, in order of “safest” to “still safe but technically riskier,” we have Treasury notes and bills, CDs, and corporate bonds. That’s also the order of lowest- to highest-yielding. CDs are still very safe (as long as they’re FDIC insured), can usually be bought commission-free, and you should be able to find some that pay a percentage point above Treasuries. Shop around for the best rates; your local bank may not be the best-yielding option.
As for corporate bonds, the general rule is to choose bond mutual funds if you have less than $25,000 to $50,000 to invest. That’s because buying individual bonds can be tricky. With a stock, you can pull up a quote on your computer and — presto! — you have a good idea of the going price. However, most bonds don’t trade on a centralized exchange. And instead of charging a commission, most brokerages (discount and full-service) embed a “markup” in the price of the bond. This makes it difficult to know what fees you paid.
It is gradually becoming easier (and more cost-effective) to buy individual bonds, so it can be done if you’re willing to put in the effort. The advantage of individual bonds over bond funds is you know exactly how much you’ll get back when the bond matures. However, since bond funds don’t technically “mature,” you don’t know what your investment will be worth when you need the money. In fact, they can lose quite a bit of money, which can be inconvenient if it happens right before you need it.
If you’re going to choose a bond fund, stick with short- to intermediate-term bonds (i.e., bonds that mature in two to five years). And be vigilant about costs — you can find plenty of good funds with expense ratios below 0.50%.
Rule 3: Any money you don’t need for more than five to seven years is a candidate for the stock market.
We Fools are fans of the stock market, and we know our history. According to Ibbotson, large-cap stocks, on average, have returned 10.4% annually from 1926 to 2007, compared to 5.5% for long-term government bonds and 3.7% for short-term Treasury bills.
However, investors in stocks have to keep that “long run” part in mind, since in the short run, no one knows what stocks will do. Make no mistake: Even if you’re in or near retirement, a portion of your money should be invested for the long term. That’s because, according to the Center for Disease Control, a 55-year-old can expect to live another 26 years. A 65-year-old has another two decades. The average 75-year-old lives into her late 80s. A 110-year-old, however, should sell everything and get to Vegas while he still can.
So unless you’re a 95-year-old skydiver who smokes, expect your retirement to last two to three decades. To make sure your portfolio lasts that long, you should …
Rule 4: Always own stocks.
Over the long term, equities are the best vehicles to ensure your portfolio withstands inflation and your retirement spending.
According to Jeremy Siegel’s Stocks for the Long Run, for every rolling five-year investing period from 1802 to 2006 (i.e., 1802-1807, 1803-1808, etc.), stocks outperformed bonds 69% of the time. Stocks beat bonds in 80% of the rolling 10-year periods, and almost 100% of the rolling 30-year periods. For holding periods of 17 years or more, stocks have always beaten inflation, a claim bonds can’t make.
But don’t forget that four-letter word
The bottom line is that when you need your money will partially dictate where you put it. What else determines your asset allocation? Risk.
Most people base their investment strategies on the returns they want, but they have it backward. Instead, focus on managing risk and accept the returns that go along with your tolerance for it. It’d be great if we could get plump returns with no risk at all. But to achieve returns beyond a minimal level, we have to invest in things that involve the possibility that we’ll lose money.
Of course, this isn’t just hypothetical theory for modern investors. The 2000s have brought us two wrenching bear markets, a mere six years apart. (Maybe there was something to all that Y2K hullabaloo after all!). Have you been able to hold on — or did you panic and sell? That’s the true test of an investor’s risk tolerance: the ability to cling to those shares as they become worth less and less, while clinging to the hope (based on history, but nothing more) that they will one day be worth more and more.
So ask yourself: What would you do if your portfolio dropped 10%, 20%, or 40% from its current level? Would it change your lifestyle? If you’re retired, can you rely on other resources such as Social Security or pensions, or would you have to go back to work (and how would you feel about that)? How you answer those questions will lead you to your risk tolerance. The lower your stomach for portfolio ups and downs, the more your portfolio should be in bonds.
As an extra aid in determining your mix of stocks and bonds, consider the following table, from William Bernstein’s The Intelligent Asset Allocator:
|
I can tolerate losing ___% of my portfolio in the course of earning higher returns |
Recommended % of portfolio invested in stocks |
|
35% |
80% |
|
30% |
70% |
|
25% |
60% |
|
20% |
50% |
|
15% |
40% |
|
10% |
30% |
|
5% |
20% |
|
0% |
10% |
So, according to Bernstein, if you can’t stand seeing your portfolio drop 20% in value, then no more than 50% of your money should be in stocks. Sounds like a very good guideline to us.
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Do Build America Bonds Make Sense for You?
June 19, 2009 by Jean Keener, CRPC, CFDP · Leave a Comment
Investors have a new mechanism for investing in municipal bonds, courtesy of the American Recovery and Reinvestment Act of 2009. As part of the Obama administration’s economic stimulus program, the bill authorized a subsidy for local and state governments that issue what are known as Build America Bonds (BABs) to finance capital expenditures.
Unlike most municipal bonds issued by a state or local government, the interest payments on a Build America Bond are taxable on your federal income tax return. However, the federal government subsidizes 35% of the interest payments on a BAB, which typically have relatively long maturities and must be issued before January 1, 2011. Those subsidies enable state and local governments to offer a higher interest rate to attract investors while at the same time reducing the cost of borrowing money to fund construction and infrastructure projects. Because of the subsidies, many muni bonds issued over the next two years are expected to be BABs.
There are several types of BABs; the governmental body that issues one determines which it will be. A Tax Credit BAB offers the bondholder a 35% federal income tax credit on the net coupon interest. A Direct Payment BAB pays the 35% subsidy directly to the issuer. Still a third type, known as a Recovery Zone Economic Development Bond, is a Direct Payment BAB that provides a 45% refundable tax credit to the governmental issuer.
Why buy a Build America Bond?
A BAB may offer some advantages that ordinary taxable municipal bonds don’t. The most obvious benefit comes from a Tax Credit BAB. Even though a BAB is a taxable bond, the 35% tax credit means that your after-tax return will be higher than the bond’s stated coupon rate. Also, the 35% tax credit may be especially valuable to investors whose marginal tax bracket is less than 35%, for whom the tax benefits of muni bonds may not previously have been as valuable. In some cases, a BAB’s net return may be as good or better than an equivalent corporate bond or an ordinary tax-free municipal bond. Your tax bracket will determine the extent to which you benefit from a Tax Credit BAB.
Even a BAB whose federal subsidy is paid to the issuer may provide benefits. The federal subsidy may enable an issuer to offer a higher coupon rate than it might otherwise have been able to afford. And though default is not impossible, munis have traditionally had a lower default rate than corporate bonds; the federal subsidies should enhance governments’ ability to meet their financial obligations.
Factors to consider
Before investing, make sure you understand whether a given BAB offers you the 35% tax credit and what that will mean given your tax bracket. Remember that the balance of those interest payments will be included as part of your taxable income, unlike most muni bonds. You may want to get assistance in determining whether a BAB makes sense for you.
New-issue BABs may be challenging for individuals to invest in. Some BAB auctions have focused on large institutional investors to the exclusion of individuals; it may be easier to find BABs being resold on the secondary market. As with any bond, BABs are affected by changes in interest rates. If interest rates rise, the value of an existing BAB with a lower coupon rate is likely to drop.