Sage advice offered by John Mugarian, investor and former Wall Street Broker:
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STEP 1: Determining Your Risk Profile
INVESTOR RISK TOLERANCE DETERMINES ASSET ALLOCATION
Investing is no different than embarking on a trip across the country. To make your trip go smoothly, you need to plan, you need a roadmap. In investing, your roadmap starts with accessing your goals, needs, and risk tolerance. If your needs call for a return of 15% per year to achieve your goal, and your risk tolerance is extremely low, there is no way you can achieve your goal. However, if your needs call for a return of 8% per year, and your risk tolerance is low, your goal can be achieved.
Let痴 get started and see if your investment objectives correspond with your risk tolerance. After you have answered the questions, and added up the points, and see what investment style fits you the best.
Question #1 � Which investment objective best describes your goals.
a) Preservation of capital 1 pt
b) Income and keeping pace with inflation 3 pts
c) 50% Growth, 50% Income 5 pts
d) Blue Chip Growth with a small mix of aggressive stocks 7 pts
e) Aggressive Growth, Income is not important 9 pts
Question #2 � What is your time horizon to achieve your goals.
a) Ten years or more 9 pt
b) Less than ten years, but more than 5 5 pts
c) Three to five years 1 pts
Question #3 � Which best describes what you expect from your investments.
a) An account that provides me with extra income 1 pt
b) An account that combines moderate growth and additional income 5 pts
c) An account that maximizes growth over the long haul 9 pts
Question #4 � The average rate of inflation is 3.5% per year. Which best describes your expectations for your account.
a) I want to keep pace with inflation while minimizing risk 1 pt
b) I want my account to outpace inflation 5 pts
c) I am willing to take extra risk to significantly outpace inflation 9 pts
Question #5 � If my starting account balance was $100,000, I would be willing to accept one of the following fluctuations of my principal to achieve the stated return.
a) 8% return = $90,000 worst year, $115,000 best year 1 pt
b) 9% return = $80,000 worst year, $120,000 best year 3 pts
c) 10% return = $75,000 worst year, $125,000 best year 5 pts
c) 11% return = $70,000 worst year, $130,000 best year 7 pts
c) 12% return = $60,000 worst year, $140,000 best year 9 pts
ADD UP TOTAL POINTS _______
STEP 2: Choosing an Allocation Model
ASSET ALLOCATION ANSWER SHEET
Investment Style: Points Historical (1970-2001) Risk/Reward
1) Aggressive 37-45 points Best +41.7/ Worst -24.1/ Ave +11.9
2) Moderately Aggressive 29-36 points Best +36.9/Worst - 19.3/ Ave +11.5
3) Moderate 21-28 points Best +29.6/ Worst -13.0/ Ave + 10.9
4) Moderately Conservative 13-20 points Best + 25.4/ Worst -6.6/ Ave + 10.4
5) Conservative 5-12 points Best + 21.7/ Worst -1.2/ Ave + 9.0
AGGRESSIVE MODERATELY AGGRESSIVE MODERATE MODERATELY CONSERVATIVE CONSERVATIVE
For long-term investors who want high growth potential and don't need current income. May entail substantial year-to-year volatility in value in exchange for potentially high long-term returns. For long-term investors who want good growth potential and don't need current income. Entails a fair amount of volatility, but not as much as a portfolio invested exclusively in stocks. For long-term investors who don't need current income and want some growth potential. Likely to entail some fluctuations in value, but presents less volatility than the overall stock market. For investors who seek current income and stability, with some modest potential for increase in the value of their investments. For investors who seek current income and stability and are less concerned about growth.
STOCKS 95%
Large-Cap Stocks 50%
Small & Mid-Cap Stocks 20%
International Stocks 25%
BONDS 0%
CASH 5%
STOCKS 80%
Large-Cap Stocks 45%
Small & Mid-Cap Stocks 15%
International Stocks 20%
BONDS 15%
CASH 5%
STOCKS 60%
Large-Cap Stocks 35%
Small & Mid-Cap Stocks 10%
International Stocks 15%
BONDS 35%
CASH 5%
STOCKS 40%
Large-Cap Stocks 25%
Small & Mid-Cap Stocks 5%
International Stocks 10%
BONDS 50%
CASH 10%
STOCKS 20%
Large-Cap Stocks 15%
Small & Mid-Cap Stocks 0%
International Stocks 5%
BONDS 50%
CASH 30%
STEP 3: Diversifying Your Investments
SIMPLIFYING YOUR INVESTMENT CHOICES
The most difficult part of managing your own investment portfolio is choosing the proper investments. In fact, this is the major sources of frustration and anxiety for many investors. Well, worry no more. Our approach is simple, easy to understand, and frankly makes the most sense. How can I make such bold claims? It痴 very simple, experience. I have watched literally hundreds of investors make the same mistakes over and over again. The most amazing part of this story is they are still making them, and are still experiencing the same results; frustration and anxiety.
To start the process, you need to ask yourself a very simple question. Are you an investor or a gambler? Sounds pretty simple doesn稚 it? Well, it really isn稚 that simple because many investors confuse investing for gambling.
If you have to constantly monitor the market and look for the next trade on the latest hot stock, you are gambling. If you like to do this, please do not confuse this with investing. Do yourself (and your financial future) a huge favor, and open two accounts. With no more than 10% of your financial assets buy and sell whatever you desire. You can even choose to pick a stock or two from the Investor Alerts—"Traders Corner". With the remaining 90%, implement a strategic asset allocation strategy and stick with it.
For your serious money however (the 90%), here痴 what we recommend for your Asset Allocation Model.
1) Large Cap Allocation: I would pick from one of the three choices below. Of course, the amount of money you have to invest will be a big factor in determining which allocation you choose. If you want to own individual stocks, it has been our experience that accounts with less than $100,000 will have a very difficult time being properly diversified in individual stocks. Regardless of your asset base, you will need to choose from one of these three allocation methods before you begin investing.
A) Individual Stocks—To get the proper diversification, you need to own a portfolio of 20-30 individual stocks. If your allocation model is moderate, and your total investment assets are $100,000, then only 35% or $35,000 can be earmarked for the 20-30 stocks that make up this large cap allocation. This means you may own 100 shares of one stock, and 35 shares of another. Since we recommend an even weighting in most of our stocks, you may have to own less than 100 shares in some positions. If this is ok with you, it痴 ok with me. If your account is greater than $100,000, owning all individual stocks in the Large Cap area will work fine.
B) Individual Stocks/Index Fund Enhancement—This allocation works better for accounts over $100,000. Most fund managers use the S&P 500 and other indexes as their benchmarks, and statistics show that they beat their respective indexes only half the time. When fund managers do beat their benchmarks, they are usually taking on more risk by overweighting stocks in a hot sector which adds unnecessary risk to your portfolio. So, by owning a portfolio of individual stocks, and enhancing the allocation with index funds, you can potentially increase your return and lower your risk.
How you might ask? Most mutual funds have a charter or rulebook they must adhere to. One of those rules is they must be fully invested at all times. So, even if a fund manager saw a train wreak coming in the market, most could not get out of the way due to the rules of their investment charters.
At the Investor Alert, we have no charters, and if we feel its time to reduce our holdings in stocks, underweight a particular sector, or protect our accounts with market hedges, we will do so. You can be sure, if we see a train wreak coming, we will get out of the way.
If you choose to own individual stocks with index fund enhancements, here痴 what I recommend. For the percentage allocated to Large Cap, invest 2/3rds in individual stocks, and 1/3rd split evenly among 2 broad based Vanguard Index funds.
1) Vanguard S&P 500 Fund- Ticker Symbol (VFINX)
2) Vanguard Total Stock Market Index- Ticker Symbol (VTSMX)
C) Index Mutual Funds—There are basically two reasons why an investor would choose to allocate their entire Large Cap percentage to index funds instead of a mix of individual stocks and funds. Both, by the way are very valid reasons.
1) The investor does not want to be bothered with monitoring the performance, or making changes in their portfolios.
2) The investor does not have enough cash to properly allocate a portfolio in stocks or a mix of stocks and funds.
In both cases, allocating your investments entirely in index funds can make a lot of sense.
2) Mid Cap Allocation: Finding the proper investments in any investment category can be very difficult, not to mention frustrating. Since many Mid Cap and Small Cap Mutual Funds have turnover rates in excess of 100% annually, it would be foolish for an individual investor to try and manage these allocations themselves with individual stocks. The safest and most appropriate way to allocate your portfolio among these groups is to use index funds.
Like I had mentioned above, some non-indexed mutual funds will from time to time outperform their respective indexes. But, once again we must ask, at what risk to the investor? Since most non-index mutual funds rarely beat the index consistently, or over the long haul, I feel it痴 more prudent to own the index. The index fund I recommend for this category is the Vanguard Mid Cap Index (VIMSX).
3) Small Cap Allocation: Use a Small Cap Index Fund for all of the reasons we mention above. Allocating assets to small cap stocks as part of a properly diversified portfolio can be scarier than watching the exorcist. I have spoken to small cap fund managers through the years, and they even admit that they rarely have the stomach to own a portfolio of individual stocks in this sector. Instead, I recommend the Vanguard Small Cap Index- Ticker Symbol (NAESX) for this portion of your portfolio.
4) International Markets Allocation: There are many wonderful Blue Chip companies around the globe. BP Amoco, Nestle� and Glaxo are a few that immediately come to mind. However, gaining access to information on foreign companies can be very difficult, if not impossible. I am not opposed to owning individual stocks in foreign companies, but to gain proper diversification, you need to also have broad exposure to many foreign markets. To do this, we once again turn our attention to index funds.
For example, the companies I mentioned above are all European. You need to have exposure to other continents as well, not to mention a blend of different market capitalizations like large, mid, and small cap sectors. For this reason, I like to use the Vanguard Total International Stock Index- Ticker Symbol (VGTSX) to broaden our exposure to a large cross-section of the world. The Vanguard Total International Stock Index is comprised of three broad stock market indexes, the Vanguard European Stock Index, Vanguard Pacific Stock Index, and the Vanguard Emerging Markets Stock Index. The fund uses a blend of market capitalizations, while properly diversifying among the top 12 sectors of the market.
5) Bond Allocation: Stocks are ownership, while bonds are loaner ship. You are loaning your money to an entity in return for a promise of a stated interest rate and the repayment of the loan on a specified date. If the entity is a corporation, interest payments are received on a taxable basis, while municipal bonds generate federally tax-exempt income. Certain other bonds, known as zero coupon bonds, do not pay any current income, but rather are purchased at a discounted price and mature at a predetermined value at a specified time.
Bond prices are impacted primarily by the rise and fall of interest rates. Quite simply, bond prices move inversely with interest rates. As interest rates increase, bond values go down. Likewise, if interest rates decline, bond values tend to increase.
To manage risk and to minimize the impact of interest rate changes, investors need to diversify their bond portfolios based on varying maturities. This diversification is known as Laddering Maturities. Laddering involves building a portfolio of bonds with staggered maturities so that a portion of the portfolio will mature each year, or some other specified time period. By spreading out the maturities, you are investing at different interest rates, with the shorter-term bonds paying a lower rate, and longer-term bonds paying a higher rate. In the mean time, you are spreading out the risk of principal fluctuation.
I recommend that investors own bonds with maturity dates ranging from 1-5 years on the short end, with bonds maturing in each of the 5 years. After the fifth year, buy bonds that mature in 5 years increments until your final maturity dates are 25 to 30 years out. You will want to invest even amounts of money at each maturity with the exception of the longest maturities. For example, if you are investing $10,000 in each maturity, you may want to only invest $5,000 in years 25 and 30.
As to what types of bonds to own, you will want to own taxable bonds in tax deferred accounts like IRA痴, and pension plans. In taxable accounts, you will have to take into consideration your tax bracket, and compare the tax free yields on municipal bonds to the after tax yields of taxable bonds.
Whatever the case, in tax deferred accounts, you want to own bonds in high quality companies that carry a bank quality rating of triple B or higher. In addition, you wanted to own some bonds that are insured or backed by the US Government. Some municipal bonds are taxable and insured, and make great alternatives to US Government bonds.
To get a more detailed explanation of bonds, comparisons, and where to buy them, go to the Reports link on my website and click on Bonds.
6) Cash: The cash portion of your portfolio should be invested in something safe and liquid. It will also serve as a place to collect and store the dividends and interest paid from your stocks and bonds. Personally, I want to avoid paying Federal as well as State intangible taxes, so I use the Fidelity Tax Free Florida Municipal Money Market Fund.
If the amount in your money market is too large and you want maximum safety, you may want to diversify into other short term (1-3 month certificates of deposits, treasuries, or tax free floaters) instruments.
STEP 4: Calculating Your Retirement Needs
CREATING A FINANCIAL PLAN
When establishing a financial plan for you or your family a "first step" is usually to take a look at a personal financial balance sheet or your Net Worth. You値l quickly get a picture of what you have, what you owe and what the net balance is of each. Examining the components of your assets and liabilities and making projections of their individual values into the future can be helpful in forecasting your financial future and your retirement needs. Accurately recalculating your net worth every six months to a year will give you a track record of how your wealth is growing or declining over time.
Go to any of the links below to start developing your own financial plan by examining where you are now, and what it is going to take to reach your goals. For example, if your asset allocation questionnaire profiled you as an "aggressive" investor (11.9% average return), and the financial planning calculator below states that all you need is 8% a year to reach your goals, you may be taking too much risk. If this is the case, then you need to adjust your allocation model from "aggressive" to a lesser risk category.
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