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Friday, April 16, 2010

DIY Newbie - Step 1 (cont.) - asset allocation

So now that you have some experience playing around with the asset allocation tool and you know that an important objective is to determine a basic percent to invest in stocks and bonds, let's take a look at some of the questions the calculator asks.

Age-Generally speaking, the older a person is, the more they should have in bonds.  The reason is very simple.  Stocks go up and they go down.  Over longer periods of time, historically, they have risen.  In fact, they have been the best performing asset class.  Thus, as long as time is on your side (that is, as long as you can bear with the down periods), you should have a sizable exposure to stocks.  But the older you are, the less time you have to wait for a snapback.  In fact, in your 60s, you are to likely to be "drawing a paycheck" off your nest egg.  You don't want to be in a position to have to sell stock in a down market to raise that money.  In fact, a really good rule-of-thumb is to not put money in the stock market if you will need it within the next 5 years.  This may seem like a no-brainer, but I've seen distraught people who put money for their child's education in the stock market with the child in 10th grade and ....well you know the rest.

Marginal tax rate - The marginal tax rate is the rate you pay on the next dollar you earn.  When it gets high enough, it makes sense to allocate assets to municipals because they are tax free - some both federal and state.

Income Required - Generally the greater percentage of your nest egg that you are drawing down, the greater percentage you should have in bonds.  A widely used rule-of-thumb says that, if you draw approximately 4% of your portfolio, the odds are you won't run out of money.

Risk Tolerance - This is a biggie and will be discussed further in a separate post.  Investors have different tolerances for risk and, I believe, it changes over time.  When volatility increases in the stock market, some people sleep like a baby and others toss and turn all night.  In fact there are stories of people waking in the middle of the night and putting sell orders in to sell all their stock because the pain is so bad.  This is typically a sign of capitulation and usually a great time to buy.  Outside reading assignment:  p. 105 and 106 in The Elements of Investing, Malkiel and Ellis.  Malkiel and Ellis wrote some of the classic books on investing.  This little volume contains a number of valuable lessons for the newbie.  These pages give you the valuable proposition:  "Know thyself and match your investing to who you are and where you are in life."

The important part of this lesson is to get an appreciation of the type of questions that you need to answer to arrive at the all important asset allocation - the percent invested in stocks and bonds.

Economic Outlook - I suggest you keep this in the middle of the range.  I know that some of you will argue that the economy is going to "hell in a handbasket" and want to reflect that.  All I can say is that, depending on your personality, it can always look bad.  Think 1932, WWII, Savings & Loan Crisis, 9/11, Housing Crisis etc.  These have all been great times to invest.


  1. Risk tolerance is the tricky one. Everyone always has a high risk tolerance in bull markets and a low risk tolerance in bear markets... part of the emotional rollercoaster of investing. Bogle's advice that your bond allocation should equal your age is pretty solid advice and can keep people out of trouble.

  2. As they say we all learned a lot about our risk tolerance in 2008.
    I agree that Bogle's advice is pretty solid but I've seen 60 year olds with 40% in the market stress out in a down market and 25 year olds walk away for good. Bonds equal age a good place to start but sometimes needs to be tweaked.
    Actually I plan on looking at a risk tolerance questionairre because this is what the financial planning community likes to do. It gives the process a sort of scientific aura and justifies high fees in my opinion.