If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan.  Stop by HERE for a complete list of classes currently available and HERE for more information about the website.

Class Objectives: To understand the basics of analyzing your personal risk tolerance and creating a plan for allocating your portfolio among stock and bond investments.
Prerequisites: SA302: Investing Basics: Time Value of Money, SA303 Investing Basics: Stocks, Bonds, Mutual Funds & ETF’s
Handout: Step-by-Step Guide to Investing
Assignment: Portfolio allocation in Excel | Google Docs (previews in lecture below)

CLASS LECTURE

Now that we’ve already covered the basic investment vehicles that beginning investors should consider, the next step is to determine how much of each of those investments you should purchase for your own portfolio.  This is where the personal in personal finance comes in.  There are general guidelines for portfolio allocation, but ultimately it depends on an individual’s tolerance of risk and their own preferences.  The stock market is inherently risky and comes with a lot of volatility, but also holds a higher opportunity for return.  The bond market is considerably less risky, but there is a more limited opportunity for returns.  By creating a portfolio with a mix of stocks and bonds (as well as a variety of stocks and a variety of bonds), this diversification will reduce the volatility of your investments overall.

We’ll start with a discussion of the risk aspect.

ASSESSING YOUR OWN RISK TOLERANCE

We all know someone that is a risk taker.  Think of some of the personality qualities which that person exhibits.  I married one, so it makes me kind of an expert (ha!).  Some of these general characteristics include being confident, independent, a leader, aggressive and even possibly irresponsible.  Physical risk takers are those who participate in activities like skydiving, car or motorcycle racing or other extreme sports.  While I have been parasailing in Bali and once “raced” my husband’s car in a cone course (it was a race, I was just a little slow to call it such!), I am pretty much the opposite of a risk taker.  I prefer mild hobbies like reading books and writing on a blog about personal finance.  (#notarisktaker).

How do you assess your risk tolerance?

A person’s tolerance of risk is affected by recent events, their familiarity with the situation, their perceived amount of control over the activity, their mood, and the time horizon.  Also, their stability of current income and liquidity will impact their risk.

A person that is a physical risk-taker may or may not be a monetary risk taker as well.  Knowledge about personal finance makes the biggest difference in whether a person is a monetary risk taker.  It definitely makes sense that the more you educate yourself about investing, the less anxiety you have about your portfolio losing money in the short-term.  So the good news here is that even if you’re not a bungee-jumper, you can increase your risk tolerance to be able to feel confident investing in the stock market by simply learning more about it and gaining experience.

While my husband prefers kiteboarding and driving at 165+ miles per hour, he does not like investing heavily in the stock market.  His views are shaped partly by not being interested in learning about the market, but even more so in the experience of seeing the impact of the Great Recession in 2008-2010.  Since we live in the Detroit metro area and he is employed by the auto industry, it meant that he saw numerous coworkers during this time having to delay their retirement for years because their retirement accounts had declined so significantly.  Many of us, even millennials, were impacted by this and it will likely influence our risk tolerance.

Many of us, even millennials, were impacted by this and it will likely influence our risk tolerance.

Investing is not a science and there is no way to predict the future outcome of any single investment, even with an index fund that tracks the entire market. Historical returns do not have any bearing on future returns.  Because you do not have any control over the market, you will ultimately feel uncertainty and some anxiety about investing at first.

Answering the following questions can help you consider how much risk you’re willing to take with your finances:

• Does a decline in the stock market cause you to lose sleep at night?
• Are you daily checking your investment balances to see if there have been changes?
• Do you hold onto your investments or sell during a market downturn?
• Are you excited about the prospect of returns on a risky investment or does it mostly just give you anxiety?
• Are you financially stable enough to be able to lose part of your investments without it having a big impact on your life?

Ultimately, if your current investments are causing you anxiety and stress, you probably seriously consider making changes.  You should either invest less aggressively or if you are already very conservatively invested you may benefit from additional investment education.

How do you assess risk with an individual investment opportunity?

When making a choice about an investment involving risk, there are 4 components that need to be analyzed:

1. The potential gain
2. The probability of achieving the potential gain
3. The potential loss
4. The probability of incurring the potential loss

By obtaining the information above for a specific investment opportunity, you can make an informed decision about how much risk you are taking on for a specific potential reward.  Knowledge is power!  With regards to the stock market, there is a big potential gain and big potential loss, but historical returns have shown that the long-term investor will ultimately receive a potential gain that is significantly more than inflation.

This chart shows the approximate risk ranking of investments from least to most risky.  Note that due to the specific nature of the investments, many of these could be more or less risky.  This is especially true with the nature of individual stocks in different industries.

Concluding Thoughts About Risk

Taking on risk is a necessary part of investing.  If you diligently save 15% of your income every year for retirement and put it in “secure” long-term treasury securities, you’ll earn a rate of around 2.5%.  This may keep up with inflation, but will likely not grow to an additional amount other than to simply keep up with the costs in the future.  However, if you consider adding in some stock and bond investments at a conservative expected rate of return of only 7.5%, your investment will grow significantly more.

Let’s assume the 15% of your income you are savings is $15,000 annually in a tax-deferred 401(k) account and you are diligent about saving this full amount for 15 more years until your retirement date at 60 years old (you’re a late starter).

• Invested in a long-term treasury security at 2.5%, your portfolio will grow to $268,979, with $225,000 being your contributions and $43,979 being the total gains.
• Invested in a stock/bond portfolio earning 7.5%, your portfolio will grow to $391,775, with $225,00 being your contributions and $166,775 being the total gains.

The decision to take on additional risk meant that you potentially could earn over $100,000 more!

The amount of risk you’re willing to take on will impact your likely return, but also your peace of mind.  It’s not worth losing sleep over to make extra money in super risky investments.

Is the risk of investing worth it?  I think, yes absolutely.  However, I still want to minimize my risk overall and the way to do that in investing is to diversify your investments through creating an asset allocation plan.

CREATING A PORTFOLIO ALLOCATION PLAN

As you can see, the mix of investments you choose for your portfolio is extremely important.  If it was easy, no one would feel that they needed to pay an investment advisor 1-2% of their portfolio to help them and a lot more than 50% of the population would be investing in the stock market.

Basic Guidelines for Portfolio Allocation

The basic guideline for portfolio allocation go something like this:

• Take 110, subtract your age and you get your suggested percentage of your portfolio that you should invest in stocks.  So for a 30-year-old, you would have 110-30 = 80% of your portfolio in bonds.  A conservative investor might use 100 (70% for a 30-year-old) and an aggressive investor may use 120 (90% for a 30-year-old).

There are many additional guidelines for portfolio allocation.  An automated tool to help you to analyze how you should allocate your portfolio between stocks and bonds based on your risk tolerance can be found on the Index Fund Advisors website: Risk Capacity Survey.  Click the Individual Investor option and choose the 25-question option.  At the end, you will need to enter your name, email address, and phone number, but it will give you the results of the survey immediately after.   You’ll receive an automated email with some additional information about the results and their company, but that’s it.

Examples of Portfolio Allocation in Professionally Managed Funds

If you’re looking to invest for retirement specifically, look up a target date fund for the year you will be likely to retire.  For example, I would look up a retirement date of 2045.  The Vanguard Target Retirement 2045 Fund (VTIVX) shows that it is made up 89.9% stocks and 9.1% bonds:

Since this is a target retirement fund with the date 2045, the manager of this fund will automatically shift the investments to more stable bond investments through time so that it is less aggressively invested and has less volatility when this group of investors is ready to retire.

If you are looking for an investment to save for college education costs, research the investments that are offered through 529 plans and see the components included by mutual fund managers.  You can either choose to invest in a target date fund or build your own portfolio.

If you are looking to invest for other reasons, be sure to match the time you have before you need to pull the money out with the specific investment.  If, for example, you are saving for a home purchase in 2 years, you will not want to invest all of your down payment in the stock market, since the risk is too great that there could be a market downturn at that time and you may lose part of your funds.

Vanguard has an extremely useful guide to portfolio allocation that shows annual average returns as well as other historical gains and losses in a variety of different portfolios (income-based, growth-based and balanced).  You can find that here.

Other Portfolio Considerations

If you have additional specific investment interests, such as investing in real estate through a REIT (Real Estate Investment Trust) or specifically in certain industry sectors, this can provide you with some confidence in your portfolio, but it is imperative that you diversify as well.  It wouldn’t be a complete discussion of diversification if we didn’t mention the saying “don’t put your eggs all in one basket!”.

If your current plan isn’t working for you, adjust it!  If you have more risk than you are able to handle, shift to more bonds.  If you are too comfortable in your portfolio and feel your rate of return is too low, gradually take on a little more risk.

On an annual basis, you should analyze your portfolio and adjust it back to your desired portfolio allocation.  For example, if you originally invested 80% in stocks and 20% in bonds but at the end of the year had a boomer year for stocks that resulted in now owning 88% stocks and 12% bonds, sell some stocks and invest them in bonds.  Alternately, you could contribute your next future earnings to bonds specifically until they make up 20% of your portfolio.  This is called rebalancing your portfolio.  Note that target date funds will be rebalanced by the portfolio manager, so it is not necessary if you go that route.

I’ve created a spreadsheet to use to determine your current portfolio allocation across all the accounts you own.  You can then compare your desired allocation and make a plan to adjust your investment plan from there.  Here is a preview of the spreadsheet, which can be downloaded by clicking directly on the preview or through the link at the top of the class.  I’ve included cash in this as well, so you may need to adjust your desired portfolio allocation based on including cash, or you can choose to leave your cash balances out altogether.

I’ve only skimmed the absolute basics, but there is so much more information readily available for those interested in investing beyond basic funds.  I’ve also provided a step-by-step guide as the handout for this class.

If this interests you, I suggest you read the book Bogleheads Guide to Investing and get started from there.

KEY POINTS IN RISK & ALLOCATION

The key takeaways from this discussion include:

• Educate yourself to be able to improve your risk tolerance and feel more comfortable investing.
• Use tools and your own risk tolerance to determine how much you should allocate to stocks, bonds, and other investments.
• Adjust your plan as needed, however, avoid panicking when the market tumbles by selling low (and buying high).
• Rebalance your portfolio annually.

EXAMPLE: THE SMITH FAMILY

The Smith family determines that they have a fairly moderate to aggressive risk tolerance level and that their portfolio should consist of approximately 85% stocks and 15% bonds and cash at their current stage of life.  In addition, because Jim is in real estate, he feels like he has a pretty good outlook on the real estate market and wants to invest some money in REIT funds.  His planned allocation is 5% cash, 75% US and international stocks, 10% bonds and 10% REIT funds.

Jim currently only has $19,393 in his 401(k) account.  Although Mary has funds in a profit-sharing account, those investments are managed separately and she does not have discretion over those investments, so they are ignored for this discussion.  The entire amount of Jim’s $19,393 is invested in a target date fund from Fidelity with the ticker FFFGX (2045 target date).  Research shows that it has the following composition:

Jim calculates his current portfolio allocation, including the cash set aside for an emergency fund in the spreadsheet as follows:

In order to add in the REIT funds, he would need to sell entire shares of the FFFGX and invest that money in the REIT, or simply put further 401(k) contributions directly to the REIT fund until it is funded in the amount he desires.  As he is currently making plans to increase his retirement contributions in the near future, he decides this is the route he will take rather than selling shares, since he feels that the current ratios are close enough to his desired allocation to leave them for now.

While target date retirement funds can be a simple solution to keep you from thinking that investing is too difficult, as long as you monitor and are happy with your portfolio allocation, you should feel free to invest in additional things that match your risk tolerance and interests.

HOMEWORK ASSIGNMENT

Your homework assignment is to analyze your risk tolerance and your current portfolio allocation based on the information learned in this class.

• IMPROVING – Take the risk survey from the IFA website and follow the suggested allocation to invest in a stock index fund and a bond index fund, or to rebalance your current portfolio.
• INVESTED – Analyze all current portfolios (retirement accounts, brokerage accounts, etc.) to determine your current portfolio allocation.  Allocate your next investment purchases to investments that are lower than the desired amount.
• UNSTOPPABLE – Read the Boglehead’s Guide to Investing book, take the risk survey, and fill out the current portfolio allocation spreadsheet and rebalance your portfolio to match the allocations that you decide on.

File your portfolio allocation spreadsheet printout and any notes you take with your “Financial Goals” in your financial plan binder.

HANDOUT: Step-by-Step Guide to Investing

If you’re ready to get started, I’ve outlined the basic steps for you in the handout below.  I can’t reiterate enough that the best way is to just get started and learn as you go!