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What Does a Proper Asset Allocation Look Like?

The Primary Asset Allocation: Equity (Stocks)

The best way to start asset allocation is at the higher level. There are a few major asset classes that we consider at the high level, you’ve got equities, which are typically stocks. You can purchase equity stocks, equity mutual funds, equity ETFs. And so a stock represents the capital of a company. You’re actually purchasing ownership of the company. 


The Secondary Asset Allocation: Fixed Income (Bonds)

The next major asset class is fixed income or bonds. You can purchase an individual bond or bond ETFs or mutual funds. The bond really just represents the debt of that company. Unlike an equity where you’re buying ownership of the company with debt, you’re actually buying the debt. They’re going to pay you an interest rate over time. And then hopefully by the end, if you choose your company well, they’re going to pay you back 100% of what you offered them, what you gave them to purchase the bond. They’ll take what you’ve given them. They’re going to use that for an investment, and they’re going to pay you back over time. Therefore, equities and bonds are the two primary asset allocation builders. 


Cash and Equivalents

Some money market funds trade like cash, which is very stable. It could be a CD. Cash and equivalents kind of fall in the bucket of ultra safe investments. You could even put three month T bills, because the three month T bill is considered one of the safest investments in the world


Alternative Investments

And then that fourth category is kind of your really different category. That’s your alternative investments that can include liquid or ill liquid investments. And those have a very low correlation, meaning they don’t move in the same direction as equities or fixed income. Some categories inside of alternatives could move a little bit like fixed income or a little bit like equities, but they still tend to move in different directions. And when you combine all four of those asset classes, that gives you an asset allocated portfolio. 


Rational Questions To Consider 

As an investor, you sit down and think: What’s my time rising? How much time do I have to invest, what’s my liquidity need? Do I have anything specific that I need to spend money on, or can I let this grow and accumulate? How much risk am I comfortable taking on? And that varies across every single investor. Some people may be 25 years old, and though they have tons of time on their side, by nature, they’re just not very risky people. So their risk profile might look very different from another 25 year old person who’s got plenty of time on their side. And they care less about risk and they want to let their money grow as fast and aggressive as possible. 


Risk Tolerance

You have to figure out what that risk tolerance is. When things are calm, you can go through some questions and figure out, what’s the point where I can’t really sleep at night after my portfolio has lost X amount? An approach to a client could be: if we put your money in the market and then a year from now, I come back to you and I say the market is up X amount, what do you want your portfolio to be up? But by the same token, before you answer that, if I come back to a year from now and say the market is down X amount, what do you want your portfolio to be down in relation to that? Overall It has to be the same on the up and the downside. If you’re willing to accept up 10%, you have to be willing to accept down 10%. And those don’t always work out exactly like that. But the key is clients need to find what measure of risk they’re comfortable with so that they can sleep at night and not worry about it. You do that on the front end when things are calm.


Stick To Your Plans

It is important to set your risk tolerance beforehand. Unless something has changed in your life where maybe you’ve lost a job, you’ve gone through a divorce or some other extraordinary event you’re really just worried about if the original risk tolerance is still intact. Then you should stick to your plan because when markets are doing things like this where they’re switching not just daily but Intraday based upon the news going on in Ukraine, that’s not the time to be making major investment decisions. That’s the time to stick to your plan and realize that you set it up for a reason. And unless something else has changed in your personal life, that plan is probably still solid.


Timing Is Everything

And that’s where I think the time horizon comes into play. How much time do they have on their side? Because that tends to guide me. First, if you’re 25 years old, the likelihood is that you’re going to be investing for the next 40 years. We’ve never, ever had a period in equity markets where we’ve lost money over 40 years. It just never happened. However, your chances of going through several bear markets over that 40 years is pretty high, at least three, probably because they tend to happen every ten to twelve years. The reality is that you’ve got to set that expectation up front and then you’ve got to figure out, okay, if the client has never, ever been through a bear market, maybe they’re just getting started. They’re 25 and they need to understand what that looks like.


Understanding Risk With Percentages 

For the average investor, in terms of dollars is probably the place to start. For example, you gave someone $10,000. Now your portfolio is worth 5000. You’ve lost half. The reason you lost half is because in 2008, from peak to trough, the SP was down 56%. If you gave me your 10,000 yesterday and today it’s worth half, that’s a whole different discussion than if you were down 50%. It just feels different for an investor. If you can start with that 50%, ie. Being the worst case scenario, 2008 was basically a three standard deviation event.


Avoid Comparing Portfolios

From the words of General Patton, “America loves a winner. And that’s what we want. We always want to win. We want our favorite team to win”. We want our portfolio to be the best. Unfortunately, we end up comparing our results to everybody else. Here’s a great example. Let’s suppose you’ve got a really close friend, and that friend gives you $50,000 at the end of the year for Christmas just to give it to you just because he’s a benevolent yeah, you would think, that’s a great friend, right? He just gave you $50,000. And so today you’re $50,000 richer than you were yesterday before he gave that gift to you. Now let’s suppose he does that for ten years, he gives you $50,000 a year. For ten years, you’re at $500,000. You just got half a million dollars for doing nothing. Now, at that moment, you’re probably ecstatic. I mean, this is the greatest thing that’s ever happened to you. You’re loving life. But let’s suppose at that last event, he also tells you where you find out that another friend that you two have in common, he gave twice as much. He gave $100,000 a year. So now at the end of ten years, that guy, that friend of yours has a million dollars. You’re probably ticked off, right? Like, what the heck did he do to deserve that? Yet just a few moments earlier, you were super pleased that you had half a million dollars for doing nothing. That’s the problem that we’re into now. We’re constantly comparing ourselves to other people.


Absolute Vs. Relative Returns

When it comes to returns in your portfolio, there’s absolute versus relative. Your absolute return is what you need to get to your goal. Your relative return is what your return looks like compared to some arbitrary index or some other person that you’re measuring your portfolio against. Maybe it’s your best friend you’ve got a rivalry with and you always want to do better than that. You really should be focused on your absolute return. As long as you stay on track, you’re going to get to your goal unless your goal changes along the way, which is possible. But as long as you stay focused on that absolute return, you should be 100%. The problem in our industry is constantly getting them to focus on an index or a blend of indexes. An index never has to keep cash. It’s always invested 100%. You may have liquidity needs where you’ve got to keep some cash in your portfolio. The index doesn’t have a life expectancy.


Risk Tolerance

You have to balance your risk tolerance with the fact that you’ve got a life expectancy and at some point, you’ve got to draw money off of your investments to live. Once you’ve retired, the index doesn’t have to compensate for distributions for spending needs, but your portfolio does. And there are other things in there, too, where really it shows the index really isn’t that relevant to your portfolio. Not to mention the fact that most people don’t have 500 stocks in their portfolio.


Balanced Portfolio

An example of where getting greedy or always looking at the best performing index can get you into trouble. So let’s take the tech bubble of 2000. We really had a nice run up from 94 to 2000. So let’s suppose you’re invested in a balanced portfolio. Your advisor has told you that’s all you need to get to your goal you’ve got to get to this goal in the next six years. So a balanced portfolio gives you what you need, you get the return you need and you’ve managed your risk according to your risk tolerance. Now in 94 and 95 excuse me, 95, 96, the SP would have generated 69% return. Your balance portfolio was only up 45%. So again if you’re stuck on these relative returns, you’re thinking I got 45% when I could have gotten 69%. So if you get into that relative scenario and you shift your portfolio to 100% equity, guess what, you do pretty good up until about 2000 and then all of a sudden tech rolls over, the SP goes lower if you stuck to your balanced portfolio and didn’t shift and stuck to your strategy at the the end of 2002 after the tech.

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