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Definitions
Stocks or equities: individual stocks, such as IBM and General Electric Equity funds: mutual funds that invest in stocks Bonds and notes: individual bonds and notes issued either by corporations or by government agencies. Bond funds: mutual funds that invest in corporate, US Treasury, or municipal bonds Fixed income:Bonds, notes, and bond funds Cash and cash equivalents: money market accounts or the 3, 6, and 12 month Treasury bills Introduction Part of becoming your own financial advisor is to determine your own comfort zone of risk tolerance and asset allocation. The internet, including some of the information on my pages, is full of advice and opinions as to how you should approach risk. My intention on this page is to provide some general guidelines that I have accumulated over the years. My own view of personal finance is to separate discretionary income (that money you have left after paying all the bills) into three categories: short term, medium term, and long term. The asset allocation for each of these can be quite different. Short term Short term investments are those that I would have on hand for emergency situations and therefore would need to be very liquid. One very real situation is loss of one's job. Money market accounts with mutual fund companies will pay you much better interest than bank money market accounts. Medium term The investments for the medium term could include individual stocks and equity funds if a time horizon of 5-7 years exists. You do not want to be saving for a house and then have a drop in the stock market take place at the time you need your money. The 2 or 3 year Treasury notes would earn a bit more interest than the money market fund and you would get back your original investment when the notes mature. Short term bond funds will fluctuate in price and there is no guarantee that you will get back your initial investment when you redeem shares. These short term bond funds tend to fluctuate 2-3% with each 1% change in interest rates. Long term The final investment category is for those funds to be used for children's education and/or retirement. This is the one area where you will see the most debate as to how your investments should be allocated between stocks, bonds, and cash. One method is to subtract your age from 100 and use this as the percentage of your investments in stocks or equity mutual funds; the remainder would be invested in bonds or bond funds. A more aggressive approach is to be 75-100% invested in stocks or equity mutual funds. This last approach requires a very long time horizon so that your investments will survive the many gyrations that definitely will occur with the equity market. As indicated above, you must determine your own comfort level of risk. This risk is not only the obvious of what happens to your investments when the stock market declines but also the risk of lost opportunity. An example is to invest $5,000 in a 30 year Treasury bond at the current (June 1998) rate of about 5.6%. You will receive semi-annual interest each year and at the end of 30 years will have your original investment returned to you. The risk of lost opportunity is the amount of money that you could have at the end of those 30 years if you had invested in a Standard & Poor's 500 index fund. Over the past 70 years, the average return for this index has been about 10%. Phantom investment assets and asset allocation Another consideration is how to include your future pension and social security benefits in your asset allocation . Each year you should receive a statement from your employer's pension plan trustee; this statement provides you with your current pension earned (in today's dollars) as well as an estimate of your benefit if you work until age 65. The Social Security Administration will provide you with a benefit estimate. A simple way to include the pension and social security income in your asset allocation is to assume that the annual income comes from an investment in 5 year US Treasury notes. These two sources of income are then considered to be in the fixed income category. The yield is currently (July 1998) about 5.4%. The following example is that of a 50 year old med tech who has been working full time since age 25. The current pension benefit is $900/month and the Social Security benefit is $1000/month. Our med tech has $422,220 in phantom investment assets calculated as follows: $22800 / 0.054 = $422,220 We make a further assumption that our med tech has been contributing $2000 per year into either a deductible IRA or 403(b) Tax Shelter Annuity over the past 25 years. This money has been invested only in equity mutual funds and has earned a 10% return each year with a 3% inflation rate. The account balance in the IRA or 403(b) is now approximately $200,000. Your first impression might be that an asset allocation of 100% in equities is rather risky for a med tech 50 years old. However, if the $422,220 phantom income is now included in the asset allocation, our med tech now has approximately 32% allocated to equities. The phantom assets from social security and the pension are now included as fixed income and make up 68% of the asset allocation.
If you are afraid of losing all your money in retirement by investing in equities, you may actually end up not having enough money to live on in your later years. The following table shows the chances of your money lasting for 30 years with various asset allocations. The withdrawl rates of 3 and 4% of initial portfolio value are considered conservative and safe; higher withdrawl rates reduce the odds you will have any money left. More information about withdrawl rates can be found in the article on Retirement Spending .
For those near retirement or early into retirement, four asset allocations seem reasonable. These suggestions are from T. Rowe Price, Vanguard, and Bob Brinker of ABC's Money Talk. As always, your comfort zone will determine which of these asset allocations you would choose.
The purpose of the cash is to provide for living expenses. The bonds can also contribute to income while also offering some protection against significant downturns in the stock markets. The stock part of the allocation is for growth; at some point the stocks/equity mutual funds will have to be converted either to bonds or to cash to provide for living expenses. |
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