Asset Allocation

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Asset Allocation

The 91.5% Solution

Presented by

William H. Keffer

Certified Financial Planner™

Goals for Today

Your comfort with basics of asset types

Your motivation to ‘control the controllable’

Action in your self interest

April 16, 2009 www.KefferFinancialPlanning.com

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Speaker Notes

Bill Keffer

Hourly, as-needed financial planner

Wheaton-based, sole proprietor

26-years AIG American General

Credentials

Certified Financial Planner®

Registered investment advisor

MBA in finance

Contributor: Investing in an Uncertain Economy for Dummies

April 16, 2009 www.KefferFinancialPlanning.com

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Introduction

Today’s focus: Asset allocation

Prerequisites:

Goals have been carefully quantified

Adequate savings are systematized

Most time on why & how to allocate

Briefly:

Distribution planning

Where & how to invest

April 16, 2009 www.KefferFinancialPlanning.com

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Definition of Asset Allocation

How you divide your money among the different classes of investment assets, such as stocks, bonds, and cash

Critical: Finding the right mix for your risk tolerance, time horizon, and required returns

April 16, 2009 www.KefferFinancialPlanning.com

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Preface

IMPORTANCE OF ASSET ALLOCATION

100%

80%

60%

91.5%

40%

20%

2%

4.6%

2.1%

0%

Drivers of Returns

Market Timing Stock Selection Other Asset Allocation

April 16, 2009 www.KefferFinancialPlanning.com

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How Asset Allocation Works

Basic concept: Impossible to predict which type of asset will do best year-to-year

Goal: A mix formulated for unique risk profile and required return

How: Different asset classes’ returns noncorrelated reducing overall risk

April 16, 2009 www.KefferFinancialPlanning.com

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Portfolio

Allocation

Asset Allocation at Work

0% Stocks

100% Bonds

100% Stocks

0% Bonds

50% Stocks

50% Bonds

5-Year Return 3.8% 8.6% 6.3%

10-Year Return

Risk

% Increase

Return/Risk

(over 100% bonds)

5.4%

2.9%

N/A

3.5%

10.4%

Ret: 126%

Risk: 259%

4.8%

5.0%

Ret: 66%

Risk: 72%

April 16, 2009 www.KefferFinancialPlanning.com

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2

3

Year

1

4

5

Arithmetic

Average

Which Would You Choose?

(based on annual returns shown)

A

10%

10%

10%

10%

10%

B

50%

10%

-20%

20%

-10%

C

30%

30%

30%

-20%

-20%

D

-30%

50%

-10%

50%

-10%

10% 10% 10% 10%

April 16, 2009 www.KefferFinancialPlanning.com

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3

4

Year

1

2

5

Arithmetic

Average

Value of $1,000

After 5 Years

Geometric

Average

Which Would You Choose?

(based on annual returns shown)

A B C

10%

10%

10%

10%

10%

10%

$1,810

10.0%

50%

10%

-20%

20%

-10%

10%

$1,425

7.4%

30%

30%

30%

-20%

-20%

10%

$1,406

7.1%

D

-30%

50%

-10%

50%

-10%

10%

$1,275

5.0%

April 16, 2009 www.KefferFinancialPlanning.com

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Rise of Index Funds

Importance of asset allocation, as opposed to stock selection, helps explain rise of index funds.

With no active stock selection going on, expenses decrease

April 16, 2009 www.KefferFinancialPlanning.com

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Examples of Asset Classes

The Two Major Asset Classes

Stocks: A share of ownership, grows through share of profits (dividends) and appreciation in market value

Bonds: A loan to a firm or government in return for fixed interest payments and promise to return principal

April 16, 2009 www.KefferFinancialPlanning.com

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Asset Class Sub-Categories

Stocks

By size of company

Large cap

Small cap

By style

Value

Growth

By location

Domestic U.S.

Developed international

Emerging markets

Bonds

By length of term

Short

Intermediate

Long

By riskiness of issuer

Government

Investment grade

“Junk”

By frequency of payments

April 16, 2009 www.KefferFinancialPlanning.com

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Other Common Asset Types

Cash (money markets, CDs, savings)

Real estate (REITs)

Commodities

Currencies

Precious metals

Natural resources

April 16, 2009 www.KefferFinancialPlanning.com

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April 16, 2009

Risk and Return

Where Asset Classes Rank

Asset Class Return Risk

Cash Equivalent

Short Term Bonds

Intermediate Term Bonds

Long Term Bonds

Large Cap Value Stocks

Large Cap Growth Stocks

Mid Cap Stocks

Small Cap Stocks

International Developed Stocks

International Emerging Stocks

5.95%

7.43%

8.20%

8.94%

10.65%

10.17%

12.05%

13.41%

11.56%

11.42%

2.82%

4.09%

6.49%

10.36%

15.01%

17.66%

16.03%

22.26%

21.35%

27.72% www.KefferFinancialPlanning.com

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Portfolio

Name

Conservativ e (38%

Stocks)

Moderate

(61%

Stocks)

Aggressive

(82%

Stocks)

A

Retu

9.01%

9.92%

rn ard

S ta nd

Dev iati on

Sample Portfolios*

(+historical returns & risk)

Cas

E q h ui val e nt

S h or t

T erm

B o nd s i d

Int e rme ate

B on ds

La rge

Cap

V al u e rge

La

Cap

G rowth

S m al l Cap

Dev el op e d

Int e rna tio nal

E m er g ing rk e ts

Ma

6.93%

10.04%

10.76% 13.20%

8%

4%

2%

24%

15%

6%

30%

20%

10%

10%

17%

23%

10%

14%

20%

5%

9%

15%

13%

18%

20%

0%

3%

4%

*Model portfolios created by Harold Evensky, CFA, for

Money Guide Pro

financial planning software, a product of PIE Technologies

.

April 16, 2009 www.KefferFinancialPlanning.com

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Determining Your Allocation:

3 Factors

Risk Tolerance

Willingness to take risk

Risk Capacity

Ability to take risk

Required Return

Need to take risk

April 16, 2009 www.KefferFinancialPlanning.com

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Risk Tolerance: Willingness to Take Risk

Questionnaire & Scoring System

April 16, 2009 www.KefferFinancialPlanning.com

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An Example: Client’s Answers &

Target Portfolio

1.

2.

3.

4.

5.

6.

Questionnaire

Answers*

Preserving capital-

Growth-

Low volatility4

Inflation protection- 5

Current cash flow4

How much risk?5

6

6

Indicated Portfolio

Allocation

Stocks:

Bonds:

Cash:

61%

35%

4%

*Scale: 1 to 9, with 1=Not Important and 9=Very Important

April 16, 2009 www.KefferFinancialPlanning.com

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Risk Tolerance: Willingness to Take Risk

Stomach Acid Test*

Maximum Tolerable Loss (%)

5%

10%

15%

20%

25%

30%

35%

40%

50%

Maximum Stock Exposure

20%

30%

40%

50%

60%

70%

80%

90%

100%

*Larry Swedroe,

The Only Guide to a Winning Investment Strategy You’ll Ever Need,

St. Martin’s Press, New York, NY, 2005

April 16, 2009 www.KefferFinancialPlanning.com

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Risk Capacity: Ability to Take Risk

The Liquidity Test*

Years Until Money Will

Be Needed

0-3

4

5

8

9

6

7

10

11-14

15-19

20+

Maximum Stock Exposure

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

*Larry Swedroe,

The Only Guide to a Winning Investment Strategy You’ll Ever Need,

St. Martin’s Press, New York, NY, 2005

April 16, 2009 www.KefferFinancialPlanning.com

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Required Return: Need to Take Risk

Years Until

Money

Needed

5

10

15

20

25

Current

Balance

$ 115,000

$ 68,000

$ 43,000

$ 25,000

$ 12,000

Amount

Needed

$ 150,000

$ 157,500

$ 165,375

$ 173,644

$ 182,326

Required

Return

5.5%

8.8%

9.4%

10.2%

11.5%

Minimum

Stock

Exposure

0%

38%

55%

72%

100%

April 16, 2009 www.KefferFinancialPlanning.com

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How to Decide When Risk

Indicators Are Mixed?

When risk tolerance, capacity and need indicate different levels of stock/risk:

Objectively re-examine tolerance

Review answers to questions

Recall what you’ve done in past bear markets

Choose level you know you can stick with

Save more

Lower or delay the goal

April 16, 2009 www.KefferFinancialPlanning.com

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Sources of Help

Online tools

Investment books & journals

Financial planner

April 16, 2009 www.KefferFinancialPlanning.com

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As Retirement Approaches…

Distribution Planning Process

Step 1: Determine retirement needs

Variables: after-tax living expenses, vehicles, travel, large gifts, etc.

Step 2: Project the results

Variables: sources of retirement income, the portfolio, expected returns, and life expectancy

Step 3: Test different options

Options: lower goals, delay goals, find new sources of income, alter the portfolio allocation, opt for a lump sum rather than a pension, use of different tools, such as immediate annuities

Step 4: Implement the best strategy

Step 5: Monitor spending & returns carefully

April 16, 2009 www.KefferFinancialPlanning.com

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Where to Invest

Accounts

Basic emergency fund in savings

Fundamental risk management (insurance)

Pre-tax retirement plans to extent of match

Roth IRA, if qualified

Additional employer plan contributions to max

Taxable investment account

Investment Vehicles

Mutual funds for most

In taxable accounts

Exchange traded funds (if amounts justify)

Municipal bonds (based on after-tax yield)

Generally, minimize holdings of individual securities

April 16, 2009 www.KefferFinancialPlanning.com

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How to Choose Among Investment

Options

Fits allocation need

Broadly diversified

Low expense ratio

Low turnover

No-load

Large, established investment company

Keep it simple!

Target allocation / lifestyle funds excellent (in most cases)

April 16, 2009 www.KefferFinancialPlanning.com

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Summary

1. Know your goals

2. Put enough $ in: top priority!

3. Allocate appropriately (91.5% solution)

4. Diversify with broad-based funds

5. Maintain discipline in rough times

6. Be mindful of costs

7. Get help if you need it

April 16, 2009 www.KefferFinancialPlanning.com

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Questions?

April 16, 2009 www.KefferFinancialPlanning.com

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