Doc’s note: I’m not about flashy investment strategies or the latest trend in stocks. Success in investing isn’t gained from a hot tip you heard at a cocktail party.
That’s why today, I’m not going to bog you down with how to create forecasts or use Nobel-Prize mathematics to optimize your portfolio. Instead, I’m sharing an essay (originally published in 2016), where I provide a simple and important step to take control of your financial future…
Please don’t let this story happen to you…
My friend’s father, who is now more than 60 years old and retired, was a successful banker in his professional life. He earned a great salary and accumulated large amounts of stock in the two major U.S. banks where he worked for years.
This stock constituted the bulk of his retirement savings. He expected it to appreciate in value and provide him with a growing nest egg. He was so confident, he kept more than 80% of his savings in just these two stocks. Then, 2008 came…
One of the banks my friend’s father owned was Lehman Brothers. This firm went bankrupt from bad mortgage bets. Shares went to zero in just months.
The other bank didn’t go bankrupt, but its shares declined more than 50% during the credit crisis (it has since been acquired by a larger bank).
As you can imagine, this former banker’s retirement is now a world away from where it was in 2008. More than half of what he expected to live on for the rest of his life vanished.
It vanished because of one tiny error in what’s called “asset allocation.”
Asset allocation can seem boring and complex (though it doesn’t need to be). And teaching you the right way to do it doesn’t make Wall Street any money… That’s why you don’t ever hear much about it.
But it’s the most important factor in your retirement-investing success.
Simply put: Asset allocation is how you balance your wealth among stocks, bonds, cash, real estate, commodities, and other investments in your portfolio.
Keeping your wealth stored in a good, diversified mix of assets is the key to avoiding catastrophic losses.
If you keep too much wealth – like 80% of it – in a few stocks and the stock market goes south, you’ll suffer badly. If you’re heavy in real estate (like many folks were in 2006), you’ll be wiped out in a big real-estate crash (like many folks were in 2008).
The same goes for any asset… gold, oil, bonds, land, blue-chip stocks, etc.
You can get an entire degree learning how to “optimize” these in your portfolio… trying to nail the perfect risk/return ratio. Heck, folks have studied the stuff in-depth and done the math behind asset allocation and portfolio theories and won the Nobel Prize for their work.
But much of the “optimization” that geeks come up with is based on forecasts and past data that are wrong more often than they are right. You can get ahead of 90% of investors with a much simpler process.
First, you start with allocating a little pile of money into an emergency fund… You should keep it liquid as cash in a savings or checking account. It makes sense to put aside enough to last you between three and six months, depending on your personal need for safety.
Once you set aside some cash for emergencies… start with a simple allocation where you decide between just stocks and fixed-income types of securities (bonds). If you have a longer-term view and a higher tolerance for risk, you could make your allocation 80% stocks and 20% bonds. If you are closer to retirement and don’t like volatile returns, you could do the inverse, 80% bonds and 20% stocks. Most of us fall somewhere in between. Personally, I’m about 50% stocks and 40% fixed income.
The point is to select assets – like stocks and bonds – that are not perfectly correlated, meaning their price movements aren’t tied to each other. Combining them in your portfolio will smooth out your overall returns.
You can easily get more complex, dividing your categories (or “allocations”) into domestic and international stocks, and corporate, government, and municipal bonds, and so on. You can even add a small allocation to precious metals, or what I call “chaos hedges.”
But before you get into all that, just start simple.
You can choose, say a 60% stock and 40% bond allocation, and stick to it. A 60% stock and 40% bond allocation is a great “middle of the fairway” asset-allocation plan. It ensures you harness the proven wealth-building power of stocks… while also using the conservative, income-producing power of bonds.
Each year, with just a few hours of work, you should rebalance your portfolio. Be sure to do it every 366 days to make sure you don’t incur a tax bill on short-term gains.
As you get closer to retirement, you can adjust it to match your risk tolerance. For example, you can use the “60/40” asset allocation while you are in your 40s, 50s, and 60s… and then start increasing your allocation to more bonds and fixed-income types of investments when you reach your 70s.
My goal today is not to load you down with mathematical formulas or stocks you should go out and buy. I’m just trying to help you develop a way of thinking that will make you a successful investor.
Just remember to start thinking about your overall portfolio. Asset allocation… it’s the only way to build wealth long term and sleep well at night at the same time.
Here’s to our health, wealth, and a great retirement,
Dr. David Eifrig and the Health & Wealth Bulletin Research Team
April 13, 2020