Asset Allocation for Dummies

I will tell you now, and I will repeat myself as necessary: I am not an expert on asset allocation. That being said, I doubt that anyone else is, either. It is impossible to describe any investing philosophy without touching on asset allocation, so following is my philosophy.

Total up all the assets of significant value you have. That includes your car, house, savings and checking accounts, expensive objects (any object worth over $1,000 is worth counting), bonds, and mutual funds and stocks.

The first key to asset allocation is that you should eliminate any high-rate debt you have. If you have bonds or mutual funds that are not in a retirement account, then you should sell them off to pay off credit card debt. It is very hard to get better returns on your stocks than the credit companies get from you. Look at paying off credit cards as a safe, easy, guaranteed investment that will yield 18%.

Now, it is my firm belief that you should always have at least six months worth of living expenses in cash-type accounts (checking accounts, savings accounts, and money market accounts). A portion of this money can be in a higher yielding short-term CD, though. Some would say this is high. At the very least, you should have two months’ worth of expenses saved. Otherwise, if an emergency comes up, you will be forced to rely upon credit card debt or to liquidate your stocks.

After you have taken care of the basics, stick the first $10,000 of your money destined for stocks into a low cost index mutual fund. I recommend Vanguard funds. This is for a few reasons. First, it ensures that even if you do something really stupid and lose the rest of your stock money, you will still be exposed to possible gains in the stock market. Second, your individual stocks may be quite volatile, and having some of your stock in an index fund will probably help you sleep at night.

Now for the rest of the money. The traditional two investments are stocks and bonds. How should you allocate how much you have in bonds versus how much you have in stocks (including your mutual fund)? Ben Graham recommended that as a value investor, you should be most highly invested in stocks when the stock market is at a low (in the depths of a bear market), and least invested in stocks when the market is at a peak (and when the future seems rosiest). How do you time when the worst of a bear market will hit, or when the peak of the bull market will come?

You don’t. All you do is gradually sell more stocks as the stock market rises, and buy more as it declines. Any cash you generate from selling you put into bonds, and when you are buying stocks, you are selling bonds. You never want to hold all stocks or all bonds, in case you are wrong and the one outperforms the other for a period of time. You do not have to perfectly time the market to do quite well using this method.

Another view on asset allocation is that it should vary with your age. The thinking is that if you are older, you will need your money sooner, and should not have as much money in stocks, which could do poorly for years. Ben Graham thought this idea was bunk, and I would agree, to some extent. While stocks as a whole may underperform bonds for a period of years, if you are doing a good job as a value investor, then the stocks you buy will tend to do okay even in bear markets. When they go down, they will tend to come back up within a period of a couple years.

Thus, I recommend a hybrid approach. As you get very old, put some money in bonds. But if you are a successful stock investor, keep investing in stocks. Also, over time, stocks have generally outperformed bonds (though this is not certain in the future). Therefore, except at the heights of a bull market, keep the majority of your investable assets in stocks.

That being said, the stock market as a whole is not cheap right now, and neither is the bond market, so an allocation of 50% stocks, 40% bonds, and 10% cash in a money market account sounds reasonable.

If even this is too much thinking (and worrying) for you, I suggest investing your retirement money in Vanguard’s excellent target-date retirement funds, which have low fees and choose your asset allocation for you.

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