Wednesday, February 14, 2007

Picking Investments and Understanding your risk profile

So, how should you pick investments and how much risk should you take? The question came in an email from my son, who is in his senior year enroute to an economics degree. Seems a bit presumptious for a plugger like myself to answer a question from someone studying economics, but perhaps experience counts for something. The question refers specifically to picking stocks and bonds.

First, let me say I practically never pick stocks and bonds. I used to do that 30 years ago, and I enjoyed the challenge. I loved the thrill of occasionally beating the averages, but I also got experience with underperfoming the market, and over several years I noticed that, on average, I underperformed the market by about 2 percent. I listened to others talk about their big winners, but when I dug a little deeper I found losers that largely offset the gains. I read the bold advertising of professionals who had beat the average over this and that period, but I noted the research that says 80% of both professional managers and individuals underperform the averages in the long term. Of course, costs were higher back then, with only a choice of full service brokerages, but the statistics still paint much the same picture. I soon realized that picking stocks, even with a professional manager/advisor was a bit like going to Vegas. You might hit big, but over the long run you almost certainly will lose a percentage of what you play, at least on a relative basis versus the averages.

Fortunately, the market is not like Vegas in its average returns. It almost always wins over the long term. So, if you can match or slightly beat the averages over the long term you can accomplish your goals, rather than gamble with them. And there is an almost surefire way to do that with index funds. And, the really good news is that with index funds you can largely negate one of the cardinal rules of investing...that a probability of high returns can only be accomplished with higher risk. I'll talk more about that later.

So, let's talk about index funds. These are funds designed to replicate the performance of their target index. Costs are one of the few things you can control in investing, and no-load index funds have extremely low costs, particularly those from Fidelity and Vanguard.

How do you pick the index funds? First, make sure you are picking from no-load, low cost index funds. The best cost nothing to buy and have an expense ratio on the order of 0.1% per year. Then decide on your allocation. This will depend on your risk tolerance, which I will discuss later, but I believe everyone should have all of the following types of funds:
  1. International
  2. Small Cap Domestic
  3. Mid Cap Domestic
  4. Large Cap Domestic
  5. Long Term Bonds
  6. Short Term Bonds, money market or cash

These can be sliced and diced more finely with value vs growth, sectors, etc., but generally I've found the above will give sufficient diversification. Then simply pick the index funds representing each class from your fund family and invest the proper percent in each. The percentage allocated to each class is known as your allocation.

What should your allocation be? This is where risk enters the picture. I have listed the above classes with the generally accepted highest risk investments at the top and the lowest at the bottom. Just allocate according to your risk tolerance.

So, how do you determine your risk tolerance? To some extent this is a personal decision. It is easy to think you have a high risk tolerance when you are not under pressure, but how will you react if things start going bad. Often, folks see their risk tolerance quite differently when they are under pressure and begin making changes in the time of stress. This approach will yield disastrous results. Make sure you are comfortable with your level of risk and stick with the allocation based on that.

Even so, there are some guidelines. Generally the risk you take should be proportional to your time horizon. If you'll need the money in a year or two, you should keep it in low risk investments. If you won't need it for 30 years or more you should take more risk. Almost everyone should have 3-6 months living expenses in short term investments, since the emergency could well arrive tomorrow. And a typical rule is that the percent invested in stocks for retirement purposes should be equal to 100 less your age, although with the system discussed in my previous post, I feel comfortable with a larger proportion in stocks.

The discussion could go on and on, but with these guidelines, you should be able to set an allocation with which you are comfortable and find the funds to satisfy that allocation, but before you do, let me discuss the relationship of diversification, dollar cost averaging and rebalancing on risk and return.

With a well diversified portfolio, risks are greatly reduced because the up and down cycles of each individual class move largely independently of each other. That means that the risk of the portfolio is much less that the risk of each individual class. Dollar cost averaging and frequent rebalancing also reduce the risk. And the beauty of it is that these measures do not reduce the return as might normally be expected by the risk/return relationship. In fact, my experience indicates that the dollar cost averaging and rebalancing increase returns over the average performance of the funds allocated by as much as 1-2% per year. This may not sound like much, but over 30-40 years this can result in a nest egg 50-100% larger than average, due to the power of compounding.

So there you have it. Assess your risk tolerance. Determine your allocation. Buy index funds regularly in accordance with your allocation to dollar cost average. Rebalance regularly. Enjoy superior returns with less risk. Throw in a little real estate (your home) for additional diversification and you are on your way to financial independence.

If you really enjoy the thrill of investing directly in stocks, set aside a small amount for that purpose, but invest for your future with the discipline outlined above and below in the previous post.

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