DETERMINING YOUR ASSET ALLOCATION

TOP ABSTRACT WHY ASSET ALLOCATION MATTERS DETERMINING YOUR ASSET... A CASE STUDY DETERMINING A SUBASSET... DETERMINING A SUBASSET... SUMMARY REFERENCES

Investment objective and time horizon. If you are like most investors, your foremost priority is a financially secure retirement. As such, your investment objective should be to accumulate sufficient assets during your full-time practicing years to maintain your standard of living as you reduce your hours or cease practicing altogether. Depending on your age, your investment time horizon will vary. On average, most people who reach the traditional retirement age of 65 years will live into their 80s. Therefore, if you are in your 40s or 50s, you likely have an investment time horizon of 30 to 40 years.

As you age, your investment horizon obviously diminishes; by the time you reach your 80s, it may be 10 years or less. However, if you plan to leave a portion of your retirement savings to your heirs, your horizon will extend well beyond your own life span. In contemplating your likely investment horizon, an important factor to consider is your family’s longevity history. If members of your family have lived into their 90s and you (and your spouse) are in good health, you probably should plan on an investment horizon up to age 100.

Many people, of course, have more than one investment objective. In a 2005 survey of more than 1,000 parents conducted by The Vanguard Group, an investment management company, and Upromise,² the country’s largest private service helping families save for college, financing a higher education was respondents’ top financial concern, ahead of saving for retirement and purchasing a home.

Your time horizon for a college savings portfolio is likely far shorter than the horizon for your retirement portfolio, usually between 10 and 20 years. As a result, your college fund portfolio should be structured more conservatively, with a more modest allocation to stocks, as you have less time to recover from steep losses in the stock market.

Risk tolerance. Your asset allocation decision also will be influenced by your attitude toward investment risk. Since perceptions of risk vary from one investor to the next, two people with essentially identical profiles—the same income level, the same financial goals, the same projected Social Security benefits and the same level of savings—may adopt quite different asset allocations.

Unfortunately, getting a feel for your level of risk tolerance is not a straightforward task. There is no universal risk scale to indicate whether you are a conservative, moderate or aggressive investor. Nor are there set rules that link a specific asset allocation to your psychological attitude toward risk. That is, for some investors, a conservative investment posture may involve investing one-half of their savings in stock; for others, a conservative posture may entail avoiding stocks altogether.

Assessing risk tolerance, then, tends to be more of an art than a science. Through the years, various questionnaires have been developed to assist investors in gauging their attitudes toward risk, but the fact remains that only you can provide a definitive answer to the question, "What level of risk am I willing to assume?" When all is said and done, it takes some knowledge of the financial markets to even begin to address this question responsibly. An Internet search engine is an easy method of navigating the myriad of financial Web sites that offer education for investors with various levels of investment experience.

Personal financial position. Your financial situation will be the final factor that influences your asset allocation decision. If you feel that your financial situation is strong and your practice is well-established and thriving, you may be in the position to assume more investment risk. On the other hand, if your practice is in its infancy and you have considerable dental school debt, you may want to assume a lower-level investment risk.

When evaluating your financial situation, you should consider factors such as the stability of your job and career, your current income relative to your income needs, your level of emergency savings and other income sources that will be available to you during your retirement.

	A CASE STUDY

TOP ABSTRACT WHY ASSET ALLOCATION MATTERS DETERMINING YOUR ASSET... A CASE STUDY DETERMINING A SUBASSET... DETERMINING A SUBASSET... SUMMARY REFERENCES

 
It may be helpful to examine the case of a hypothetical couple and how they may allocate their investment assets given their investment objectives, time horizons, tolerance for risk and financial situation. Edward, 45, has an established practice of 15 years and little debt beyond his home mortgage and a monthly car payment. His wife, Ann, stays at home with their two children, who are aged 3 and 8 years. Edward has contributed regularly to a simplified employee pension plan (commonly known as a "SEP-IRA") and has amassed a balance of $400,000, all of which is invested in stocks. He also has college savings programs for his two children, with balances of $15,000 and $40,000.

The couple’s goals are a secure retirement for themselves and financing college for their children. Edward and Ann were fairly aggressive investors until the bear market in the early 2000s resulted in considerable losses in their technology stock holdings and shook their confidence. While still willing to accept the volatility of stocks, the two learned a valuable lesson about downside risk and now recognize the importance of diversifying their stock holdings.

Given a stable financial situation and long-term horizon of 40-plus years, Edward and Ann’s retirement portfolio should reflect a fairly heavy allocation to stocks, in the 70 to 80 percent range. Factoring in the couple’s more moderate appetite for risk, a portfolio consisting of 70 percent stocks and 30 percent bonds may be appropriate.

The college portfolio for the couple’s 3-year-old could be allocated similarly, given the 15- to 20-year horizon. For the 8-year-old, a more conservative approach would be advisable. In this instance, a portfolio split equally between stocks and bonds might be appropriate, with a gradual shift to bonds and short-term investments as the child nears college age.

Of course, this hypothetical example oversimplifies the asset allocation decision to some degree, but it addresses the importance of approaching the matter from a strategic perspective. Once you have decided on an appropriate asset allocation, you will need to allocate your investments within each asset class. This tactical suballocation of your assets among the various segments of the stock and bond markets will serve to diversify your portfolio further.

	DETERMINING A SUBASSET ALLOCATION FOR STOCKS

TOP ABSTRACT WHY ASSET ALLOCATION MATTERS DETERMINING YOUR ASSET... A CASE STUDY DETERMINING A SUBASSET... DETERMINING A SUBASSET... SUMMARY REFERENCES

 
You’ll have three primary decisions when allocating the stock portion of your portfolio:

– how much to invest in large, medium and small companies;

– how much to invest in growth stocks versus value stocks;

– how much to invest in domestic stocks versus international stocks.

The domestic stock market can be segmented in two key ways: by company size and by investment style. Both are important considerations in choosing an appropriate mix of stock investments.

Consider market capitalization. The size of a company typically is measured by market "cap," its stock price multiplied by the number of shares outstanding. For instance, if a company has 1 million shares outstanding that sell for $10 per share, then it has a market cap of $10 million. Over short periods, total returns can vary significantly from one segment to another, as shown in Table 2.

View this table: [in this window] [in a new window]   TABLE 2 Investment returns and market capitalization.*

How should you divide stock investments among large-, mid- and small-cap stocks? A place to start would be to market-weight your holdings, which would help to keep investment returns in line with the performance of the entire U.S. stock market. Table 2 illustrates how the U.S. stock market is allocated among large-cap (70.9 percent), mid-cap (24.7 percent) and small-cap companies (4.4 percent). You should consider these ranges to achieve market-neutral diversification in your own portfolio.

Size up investment style. The next consideration is investment style: growth stocks versus value stocks. Growth-oriented stocks have strong earnings and revenue potential and offer above-average prospects for capital growth. In contrast, value-oriented stocks are attractively priced, perhaps because they are out of favor or because investors have low expectations for them. The box offers a snapshot of the differences between the two types of stocks.

Contemplate international stocks. Investing in stocks of overseas markets provides the opportunity to dampen the overall risk of an all-U.S. stock portfolio. Indeed, U.S. and foreign stock markets often have moved in different directions at different times, or in the same direction but by different magnitudes.

At the same time, investing abroad entails additional risks. Foreign companies and stock exchanges do not follow the same rules and regulations as do U.S. companies and exchanges, and they generally are subject to less governmental supervision. In addition, international stocks are subject to country risk—the potential for stocks to decline as a result of political turmoil, financial problems or a natural disaster—as well as to currency risk.

International stocks represent approximately 50 percent of the global equity market. A market-weighting of international stocks might not be prudent, especially for more conservative investors, given the additional risks involved. Some advisers recommend that international stocks represent no more than 20 percent of your overall equity holdings.

	DETERMINING A SUBASSET ALLOCATION FOR BONDS

TOP ABSTRACT WHY ASSET ALLOCATION MATTERS DETERMINING YOUR ASSET... A CASE STUDY DETERMINING A SUBASSET... DETERMINING A SUBASSET... SUMMARY REFERENCES

 
As with your stock decision, you will have three primary decisions when allocating the bond portion of your portfolio:

– the tax liabilities associated with the bonds;

– the quality of the bonds;

– the maturity of the bonds.

Examine tax status. If you are in a higher tax bracket (28 percent or higher), you may obtain a higher after-tax yield by investing in tax-exempt bonds (or bond funds), even though the yield is lower than the pretax yield on comparable taxable bonds. You can use a simple formula to help you decide whether you should invest in taxable or tax-exempt bonds:

If the taxable-equivalent yield of a tax-exempt bond or fund is higher than the yield on a taxable bond or fund with a similar maturity, then you may wish to choose the tax-exempt route. If the yield of the taxable fund is higher, then the taxable fund would provide the higher yield even after taxes are paid.

Weigh maturity. You also should consider the maturity of a bond or average maturity of a bond fund. Longer-term bond funds usually provide higher and more stable interest income, but they also fluctuate more in value. Bond funds can be classified as short-term (average maturity less than five years), intermediate-term (average maturity five to 10 years) and long-term (average maturity more than 10 years).

Historically, intermediate bonds have provided 90 percent of long-term bonds’ income with about one-half the volatility. Many bond fund investors choose to maintain a bond portfolio with an average maturity of between five and 10 years. This does not require investing solely in intermediate-term bond funds; you can hold a mix of short-, intermediate- and long-term bond funds.

Evaluate credit quality. "Credit quality" refers to a bond issuer’s ability to repay the interest and principal of its bonds. The highest-quality bonds are U.S. Treasury securities, followed by other U.S. government bonds and then by high-quality corporate bonds.

In general, lower-quality bonds pay a higher interest rate to offset the increased risk that principal and interest will not be paid in full and on time. As a result, bond funds that hold high-quality corporate bonds generally provide higher current income than U.S. government bond funds with similar maturities. By investing more assets in well-diversified, high-quality corporate bond funds than in government bond funds, investors may obtain a higher yield with a degree of additional risk. However, if you live in a state with a high income-tax rate, you may want to consider a U.S. Treasury bond fund, because the interest income on those bonds generally is not subject to state income taxes.

	SUMMARY

TOP ABSTRACT WHY ASSET ALLOCATION MATTERS DETERMINING YOUR ASSET... A CASE STUDY DETERMINING A SUBASSET... DETERMINING A SUBASSET... SUMMARY REFERENCES

 
This article describes a framework for developing an investment portfolio that helps meet your unique needs. You may want to review your existing portfolio to determine if the asset allocation and suballocation are appropriate to your circumstances. If not, changes may be made best within tax-deferred accounts so that you do not incur significant tax liability as you reposition your portfolio.