portfolio. You’ve heard it before. But what is the best combination of
investments? What percentage of your portfolio should be in stocks? Bonds? Real
estate? Gold? How should you weigh the pros and cons of foreign and domestic
investments? Should the allocation be different depending upon whether the
account is your practice retirement plan, your IRA, or your taxable investment
accounts? When doctors stopped by my booth at the 2007 Star of the North
Meeting, their most frequent and fervent questions were about asset allocation.
Financial planning is a blend of art and
science. There is no consensus in the investment community on the single best
way to approach asset allocation, but there are academically validated methods
to assemble financial portfolios. When I work one-on-one with clients, we
design a unique plan based on specific life goals, risk tolerance, current
asset holdings, and retirement dreams. Asset allocation is a key to achieving
the long-lasting financial security every doctor
Timeframe, and Risk Tolerance: What Works for You?
How soon do you want to be financially independent? Do you
know what it will take to get there? The longer your time horizon, the higher
level of risk you can incur today. If you are 35 and plan to work for 30 more
years, you have the luxury of years to absorb short-term losses. If you are
closer to retirement and are on track to accumulate enough assets to be
financially independent by the age you’re aiming for, you can dial down the
risk level in your portfolio.
Investment volatility means potentially
greater gains — and pitfalls. How much loss can you stand before you bail out
and sell an investment? We all want big financial rewards; however, risk
tolerance is a highly personal preference. If you are an aggressive investor,
you are willing to accept more risk in exchange for the opportunity to get a
higher return. If the idea of market volatility and financial loss keeps you up
at night, a more conservative approach is probably for you. Protect your
principal and enjoy incremental gains with peace of mind.
Once you reach retirement, asset
allocation takes a new spin. Consider this: You’re 65 today. Assuming a modest
three percent inflation rate, by age 85, today’s 41 cent stamp will cost 74
cents. Today’s $30,000 automobile will cost $54,183. If a $1,000,000 bond
portfolio yields five percent ($50,000/year), and inflation is three percent,
over time the $50,000 of annual interest on your bonds will not keep pace with
inflation, and your purchasing power — i.e. your standard of living — will
decline. Inflation is the enemy of a fixed income portfolio, and you need a
portion of your portfolio protected against it. Stocks are an asset class that
has a real return against inflation. So, in retirement you should still
maintain a significant portion of your portfolio (50-70%) in stocks.
Options, Making Choices
To assemble a diverse portfolio, you are
most commonly working with stocks, bonds, and cash. It is as important to
allocate funds within each asset category as it is to diversify between them.
Of the three major types of assets, stocks (that is,
ownership in a company) have historically the highest return and the greatest
risk. Your risk tolerance will figure into your choices concerning which stocks
to invest in. However, regardless of your taste for risk, stocks (or equities)
should figure prominently in your portfolio.
Domestic vs. foreign, small cap vs. large
cap, value vs. growth. Over time, different kinds of stocks gain and wane in
popularity. Since it is impossible to predict ahead of time which type of stock
will fare best over the next three to six to 12 months, it is best to have some
money allocated to each. While the return on the portfolio will never be as
high as if you had all your money in what turns out to be the best performing
area, your losses will never mirror the poorest performing area.
One issue I see in portfolio construction
is concentrated stock positions; that is, having a large part of the portfolio
in one stock. This concentration is often the result of an inheritance, a
spouse’s employee stock purchase/plan or 401(k), or even from a long-time
holding that has done well and become a very large holding — a situation that
often leads people to be reluctant to sell off a portion. Concentrated stock
positions raise the volatility of a portfolio. If you have one stock making up
10% of your portfolio, this should raise a red flag. Twenty percent or more?
Trim the position.
Bonds are a money-lending vehicle. Corporate bonds lend money
to corporations, municipal bonds to cities, treasury bonds to the U.S.
government. During the life of the bond you receive interest payments, and at
the end of the term you are paid back your principle. Bonds are less volatile
than stocks, in part because as long as the entity to which you loaned your
money to remains able to operate, you get the money you originally loaned them
back. It is important to have both stocks and bonds in your portfolio as bond
values vary at a slower rate than stocks and help smooth out the bumps. They
also add to diversification because they have a low correlation with the stock
market. During the last eight bear markets going back to 1968, when stocks as
measured by the S&P 500 were down an average of 25.2% per bear market,
bonds, as represented by five-year treasury bonds, were actually up an average
of 9.8%. In the dark days of a bear stock market, asset diversification will
help you sleep better.
Within the bond market itself there are
different types available, including investment grade bonds and high yield
bonds. Bonds also vary by duration: short-term, intermediate, and long-term.
The longer the duration, the more sensitive the bond is to fluctuations in
interest rates. Municipal bonds, which when issued by governmental entities in
your own state are free of state and federal taxes, are often a good choice in
Call it cold, call it hard, cash is what it is: money in a
savings account or money market fund. Cash won’t earn much return, particularly
when measured against inflation, but these assets will not lose value.
• Like bonds, real estate and commodities have a low
correlation with stocks and can help smooth out the ups and downs.
• Any assets you don’t want to own? For example, many health
care professionals are not comfortable owning tobacco stocks.
• The asset allocation you choose today should not be static.
If you are 40, and plan to work to age 65 and believe a portfolio that is 90%
stocks and 10% bonds is right for you, it would be wise to reevaluate the
allocation at, say, age 45. Despite a bull or bear market in the interim,
reevaluation is necessary because you are now five years closer to retirement.
to Your Plan
Once you have worked through your goals, your time horizon,
your risk tolerance, and decided upon your asset allocation percentages, write
it down. A written Investment Policy Statement (IPS) will help you stay on
course and maintain a clear vision for your portfolio.
If you have decided that an allocation of
80% stocks and 20% bonds is a good fit, and the stock market subsequently goes
down 30% in value, you may be tempted to sell your stocks and bail out of the
market. This action falls under the classic investor error of buying high and
selling low. Referring to your IPS will help you remember why you chose the
80/20 allocation and stick to it. By the same token, if you’ve started with an
80/20 mix and the stock market goes up such that your portfolio is now 90/10,
reviewing your IPS will help you rebalance by selling stocks when they are up
and returning the portfolio to 80/20.
The underperformance of the average
investor is not just a numbers game, it is a direct impact on quality of life.
The question is, how long will you work before you’re financially independent? Choosing
to stay gainfully employed certainly beats being chained to the dental chair.