Risk vs. Reward: Finding the Right Asset Balance for You

There are inherent risks in investing (you can’t control the market) but there are potential payoffs that help people tolerate that risk (like funding retirement). To better understand your own tolerance for risk, you need to first get the gist of asset allocation.  Asset allocation is a technique used to spread your investment dollars across different asset classes.  Stocks, bonds, and cash or cash alternatives, among others, are generally the most common components of an asset allocation strategy. 

Determining risk tolerance

Deciding on an appropriate allocation is an important exercise because it may be the most important investment decision you make due to the impact it can have on your overall return.  Your financial goals, time frame and personal resources all contribute to the equation. A risk profile questionnaire is a widely accepted method to help advisors and investors make asset allocation decisions.  

However, there are two significant limitations to relying solely on a risk questionnaire to make the asset allocation decision.  First, the way people think about risk is not stable and very often varies with market conditions.  Behavioral science research tells us that when the market goes up, the pain of past plunges typically fades as investors feel they can accept more risk.  The dynamic reverses when markets correct or go down.  Suddenly, the market elicits fear in the hearts of investors and tolerance for risk diminishes.

The second limitation with risk questionnaires is they don’t measure an individual’s need to take risk.  The purpose of an investment portfolio is to support the financial planning objectives or desired lifestyle. The plan will articulate the why as well as the how.  It helps answer questions like, “So, can I retire?” or, “Do I have enough to feel confident?”  The specific goals and time frames are the determinants of how much risk to take, even if there is a willingness to take on additional risk.

Committing to an asset allocation

Picking an asset allocation is important, but committing to it is even more important; especially in light of our changing attitudes about risk and reward.  Don't hesitate to get professional help if you need it. And be sure to periodically review your portfolio to ensure that your chosen mix of investments continues to serve your investment needs as your circumstances change over time.

Laurie Renchik, CFP®, MBA is a Lead Financial Planner at Center for Financial Planning, Inc. In addition to working with women who are in the midst of a transition (career change, receiving an inheritance, losing a life partner, divorce or remarriage), Laurie works with clients who are planning for retirement. Laurie was named to the 2013 Five Star Wealth Managers list in Detroit Hour magazine, is a member of the Leadership Oakland Alumni Association and in addition to her frequent contributions to Money Centered, she manages and is a frequent contributor to Center Connections at The Center.

Five Star Award is based on advisor being credentialed as an investment advisory representative (IAR), a FINRA registered representative, a CPA or a licensed attorney, including education and professional designations, actively employed in the industry for five years, favorable regulatory and complaint history review, fulfillment of firm review based on internal firm standards, accepting new clients, one- and five-year client retention rates, non-institutional discretionary and/or non-discretionary client assets administered, number of client households served.

The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.  Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.  Any opinions are those of Center for Financial Planning, Inc., and not necessarily those of RJFS or Raymond James.  Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment.  Prior to making an investment decision, please consult with your financial advisor about your individual situation.  Asset allocation does not ensure a profit or guarantee against a loss.

Investing is a Marathon, Not a Foot Race

 I had lunch with a friend that turned 40 years old last week.  He mentioned that he runs in a few marathons. He used to run dashes.  A marathon is a lot different from a 100-yard dash.  Preparation is different, psychologically, mentally and physically you prepare differently.  

He changed his portfolio over the last few years because of the market volatility.  This new portfolio was geared towards mitigating risk in the next few months; kind of like a foot race but he is not considering the implications of the next 25.5 miles. Three things came to mind as I was looking at his new selections.  First, I had my research assistant run some analytics on the two portfolios and then compared the old and new. 

Old Portfolio:

• Centered on equities
• 10 year plus time frame
• Partially passive and partially active approach
• Focus on growth rather than risk, liquidity or safety

New Portfolio:

• 5 year or less time frame
• Focused on a possible need for current income
• Very risk adverse (actually underperforming the market by 2-3% annually)

After taking a look at his portfolio changes and the implications, I offered these three suggestions:

#1 Find a consultant that understands what you want to accomplish.

Sit down and let a planner you trust (that has a similar investment philosophy) really get to know who you are and what your family goals are. Talk about what you want your portfolio to accomplish.  Complete that firm’s financial planning questionnaire, risk tolerance questionnaire, etc.  Start out with someone who is a CFP or has a vast background in working with family planning situations and money.  Pick a person who wants to keep you on track over the next 20-30 years. 

#2 Develop an asset allocation that is right for you.

First you should clearly articulate your goals.  After that is done, get the right mix of asset classes in your portfolio.  Don’t worry so much about the actual investment selection – it has the least amount of validity in the entire process. Look for managers that have 10 years experience and an average or better track record.  If possible select investments that have a small asset base. They may be more nimble than large investments. 

#3 Meet annually with that planner.

And lastly, meet once a year (both you and your spouse) for an hour or two with that planner to discuss your goals, feelings, and perceptions of your planning. Reviewing your financial situation periodically is an important part of the financial planning process; it helps maintain forward momentum, establishes a checkpoint to assess progress, refocus efforts, and ultimately helps you cross the finish line you’ve set for yourself.

Matthew E. Chope, CFP ® is a Partner and Financial Planner at Center for Financial Planning, Inc. Matt has been quoted in various investment professional newspapers and magazines. He is active in the community and his profession and helps local corporations and nonprofits in the areas of strategic planning and money and business management decisions. In 2012 and 2013, Matt was named to the Five Star Wealth Managers list in Detroit Hour magazine.

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Five Star Award is based on advisor being credentialed as an investment advisory representative (IAR), a FINRA registered representative, a CPA or a licensed attorney, including education and professional designations, actively employed in the industry for five years, favorable regulatory and complaint history review, fulfillment of firm review based on internal firm standards, accepting new clients, one- and five-year client retention rates, non-institutional discretionary and/or non-discretionary client assets administered, number of client households served.

The information contained in this report does not purport to be a complete description of the securities, markets or developments referred to in this material.  Any information is not a complete summary or statement of all available data necessary for making an investment decision.  Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment.  Prior to making an investment decision, please consult with your financial advisor about your individual situation.  Any opinions are those of Center for Financial Planning, Inc., and not necessarily hose of RJFS or Raymond James. Asset Allocation does not ensure a profit or protect against a loss.  Investing involves risk and investors may incur a profit or a loss regardless of strategy selected.

Helping Clients with Asset Allocation

 In most books that discuss asset allocation, the author will mention at some point the relevance of strategic asset allocation and it being a prominent component to the investor’s outcome, which is typically measured in volatility and return.   At the Center for Financial Planning one of our core investment beliefs works with strategic asset allocation.  We believe there is an appropriate mix of assets that can help investors pursue their personal set of goals during volatile market conditions.  

Below is a chart of a new client that recently came in for a financial plan overhaul.  You can see they had quite a difference in their current allocation to that of our recommended strategic allocation.  The current allocation in blue is overweight US Large Cap stocks and International Large Cap stocks while underweight in some of the more non-correlated assets like Strategic Income and Strategic Equity.  We were able to look over their outside investments in 401k’s, and 403b’s to help obtain what we determined to be a suitable mix, designed to keep them within their volatility comfort range as well as on track to reach their return expectations over the long haul.

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These asset allocations are presented only as examples and are not intended as investment advice. Actual investor results will vary. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Although derived from information which we believe to be reliable, we cannot guarantee the completeness or accuracy of the information above. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investments mentioned may not be suitable for all investors. Any opinions are those of Matthew Cope and not necessarily those of RJFS or Raymond James. Investing involved risk and asset allocation does not ensure a profit or protect against a loss.
1. Core Fixed Income includes: U.S. Government bonds and high quality corporates
2. Strategic Fixed income includes: Non U.S. bonds, TIPS, less than high quality corporates and other bonds not in core fixed.
3. Strategic Equity includes: Hybrid managers, REITS, hedgeing strategies, commodities, etc.

Time to Declutter?

Do you ever feel like this when thinking of your portfolio?  Making investments without factoring in your investment process could end up adding more clutter to your portfolio without adding any value.

As you might recall the investment process starts with Strategic Asset Allocation, which is the establishment of your mix of stock, bonds and cash (see my post from 11/4/11).  Followed by layering in tactical allocation, overweighting or underweighting asset classes as the opportunity arises (see my post from 12/2/11).

Choosing the proper type of investment is vital to the continuation of your process.   There are many different types of investments that may be appropriate for you.  Individual company stock is usually the first that comes to mind for investors.  Common stock represents direct equity ownership in a corporation.  Returns can come from dividends paid or price appreciation.

One could also purchase bonds issued by many of these same companies, as well as governments or municipalities.  This means the entity owes you your principal at a specified date in the future and interest in the mean time in exchange for borrowing from you.  Many factors need to be considered when investing in a stock or bond and this can be overwhelming even for many investment professionals.  So many investors turn to professional money management.

Professional money managers can take two basic approaches to investing.  First, active management is simply an attempt to "beat" the market as measured by a particular benchmark or index.  Passive management is more commonly called indexing. Indexing is an investment management approach based on investing in exactly the same securities, in the same proportions, as an index.

So if you find yourself buried in stacks of paper every month talk to your Investment Professional to de-clutter your portfolio and determine which types of investments may be appropriate for you.

Dividends are not guaranteed and must be authorized by a company’s board of directors.  Bond prices and yields are subject to change based upon market conditions and availability.  If bonds are sold prior to maturity, you may receive more or less than your initial investment.  Holding bonds to term allows redemption at par value.  The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material.  Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.

Deck the Halls with Tactical Allocation

One of my favorite things during the Christmas season is to decorate my house.  When driving down the street, my house tends to be the eye-catching one... think the Griswold house. As we string lights, hum Christmas tunes, and watch my husband crawl around on the roof with his staple gun, we really get into the holiday spirit. 

Now, let's put my slightly over-the-top "ode to the holidays" in investment terms. I recently explained that strategic investing, when you pick the mix of stocks, bonds and cash to make up your portfolio, serves as the foundation of your house. Well, I like to think of Tactical Allocation as decorating or changing for the season.  Of course, it shouldn’t be as drastic of a transformation as the Griswold’s (we don't want to blow a fuse or catch the tree on fire). Rather, a Tactical Allocation approach provides for overweighting or underweighting asset classes as perceived market opportunities arise. In yard decorating terms, you're not leaving the inflatable Santa out in the yard all year, that would be the traditional investing “buy and hold on for dear life” approach. You're watching conditions and judging when it's the opportune time to deflate old Saint Nick,  pack him away and move on to the next holiday. The goal of Tactical Allocation is to reduce risk, increase returns or both. 

While we believe that the relationship of valuation between markets over long periods will be efficient and will correspond to fundamentals, we also acknowledge that over shorter periods, some markets may become overvalued, while other asset classes will become undervalued. This is where Tactical Allocation can be considered. A somewhat modified asset allocation can potentially offer better returns and less risk when executed correctly.[1]

A tactical asset allocation strategy can be either flexible or systematic.  In a flexible approach an investor modifies his portfolio based on valuations of different markets or sectors (i.e. stock vs. bond markets).  Systemic strategies are less discretionary and more model based methods of uncovering market anomalies.  Examples of these are trend following or relative strength models. 

All of these methods require knowledge, discipline and dedication to execute successfully; it's not like throwing a single strand of lights over a tree branch and calling it festive. And with Tactical Allocation, less can be more, which is an approach I sometimes wonder if I should apply to my Christmas decorations. So, talk to your Financial Planner to determine what may be appropriate to incorporate into your portfolio.

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[1] Keep in mind that all investing involves risk, and there is no assurance that this or any strategy will be profitable nor protect against loss.

Building Your Foundation

Contributed by: Angela Palacios, CFP®

Asset allocation is like the foundation of your house. It is the most important structural part of your investment process. Without it, your home or your financial plans could become extremely unstable. 

Many investors either become paralyzed and unable to make decisions, or make decisions by constantly chasing the recent past and, thus, earning dismal returns.  To avoid those mistakes, one of the first and most important steps in investing is determining your Asset Allocation. 

An Asset Allocation Model is usually the outcome of the financial plan you complete with your investment professional. Its goals are normally to identify the mix of assets that best balances an investor’s desire for return with the desire not to take undue risk.  Studies have shown that asset allocation decisions account for a significant amount of the variation of total returns, while security selection accounts for a relatively small portion of the variability of total returns.  The most notable study was done in 1986 by Brinson, Hood and Beebower.  The researchers found that the asset allocation policy explained 93.6% of the average funds’ variation over time. 

In its simplest form, Asset Allocation is the percent of stocks, bonds, and cash you would own in a world of normal valuations.  Generally, allocations with more stocks than bonds would be in the “High Risk/High Return” area of the line on the “Efficient Frontier” chart below.

Disclosure:  The “Efficient Frontier” is a concept derived from Modern Portfolio Theory.  According to the theory, it is possible to construct an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk.

This chart can change greatly depending on the time period you use to draw it.  The following is how the above chart varies in actuality decade to decade.

© Dorsey Wright & Associates

In the 1960s, 1980s and 1990s stocks significantly outperformed bonds. While the 1970s and the 2000s show a much different story. Not only were stocks an underperforming asset, but the risks involved were very high using standard deviation as our risk scale. (The Weiss Report, Vol. 13)

While careful Asset Allocation can help make your investment portfolio structurally strong, unlike the foundation of your house, shifting investments can be a good thing. In practicality your Asset Allocation, rather than being static, can be changed tactically to reflect current market conditions as shown above.  Watch future posts to find out more about using asset allocation and other investment strategies. 

Angela Palacios, CFP® is the Director of Investments at Center for Financial Planning, Inc.® Angela specializes in Investment and Macro economic research. She is a frequent contributor The Center blog.

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Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Center for Financial Planning, Inc., and not necessarily those of RJFS or Raymond James. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Asset allocation does not ensure a profit or protect against a loss.