The Financial Survival Guide to
Retirement
Investment Theory
Review
• Asset allocation is the single biggest determinate of
portfolio results
• Major asset classes
– Stocks
– Bonds,
– Cash
• How you allocate your investments depends upon
the returns you need and risk you can take
• Rule-of-thumb: %stock = 100 - age
Where We Stand
•
You have determined your:
1. Investment objective
2. Risk tolerance
3. Asset allocation
•
Now - what investments
do you buy in each
asset class?
Financial Planner Exercise
• Who is the best financial planner in class?
Modern Portfolio Theory
• Asset class investments tend to move together –
correlation
– For example, in a recession
• But investments do not always move together
– For example, high oil prices are good for oil
companies but bad for airlines
– Bad quality may affect only one company
• Diversifying your investments, can increase your
average return and lower your risk!
Not All Risk is the Same
Firm Risk = Systemic risk + Idiosyncratic Risk
Business
Cycles
Financial
Markets
Global
Conditions
Risk Unique to the
Firm
Source of Correlation
Idiosyncratic risk can be diversified away!
Diversification – Simple Example
IBM and AT&T
When IBM went down, AT&T went up.
When AT&T went down, IBM went up.
Not always. Maybe we should add more
or different stocks.
With large portfolio, 30 – 200 stocks, idiosyncratic moves cancel out!
Adding Investments
Can Reduce Risk
Risk and Diversification
Note: adding some stock to a 100% Treasury portfolio increases the return and
decreases the risk!
Modern Portfolio Theory
• Optimal portfolios are a combination of the
risk free asset and a market portfolio.
• Implications
– Buy a money market fund (~risk free)
– Buy an index fund (the market)
– Asset allocation is determined by your risk
tolerance
• Big Question – what is the market?
Modern Portfolio Theory
Foreign Diversification
Efficient Markets Hypothesis
• Markets prices reflect all known information
• You can not beat the market consistently without luck
– Advisors may be correct, just not consistently
– Advisors love to talk about winners but not losers
– Survivorship bias
• What to do?
– Go with the market
– Invest in broad market index funds
– Less than 3% of actively managed funds beat index funds over
last 20 years*
* “Index Funds Win Again,” NY Times, Feb. 22, 2009.
Index Funds
• A fund is a pool of securities that allow investors to
buy a share of many securities
• Many index funds available for stocks and bonds
Vanguard
Index 500
Total Stock Market Index
Total Int’l Stock Index
Total World Stock Index
Long Term Bond Index
Fidelity
500 Index
Total Market Index
International Index
U.S. Bond Index
Schwab
S&P 500 Index
Total Stock Market Index
International Index
Target Date Funds
• “Index” Funds whose asset allocation
becomes more conservative over time
• Percent of stocks goes down, bonds go up
• Issue
– What happens after target date?
– You still have many years to go
– Retirees face inflation risk, do not want to be too
conservative
– What does fund do after target date?
Building Your Market Portfolio
Scott Burns' Lazy Portfolios
Coach Potato Portfolio:
- 50% in Vanguard Total Stock Market Index Fund (VTSMX)
- 50% in Vanguard Inflation Protected Securities Fund (VIPSX)
Margarita Portfolio:
- 33.3% in Vanguard Total Stock Market Index Fund (VTSMX)
- 33.3% in Vanguard Inflation Protected Securities Fund (VIPSX)
- 33.3% in Vanguard Total International Stock Index Fund (VGTSX)
Four Square Portfolio:
- 25% in Vanguard Total Stock Market Index Fund (VTSMX)
- 25% in Vanguard Inflation Protected Securities Fund (VIPSX)
- 25% in Vanguard Total International Stock Index Fund (VGTSX)
- 25% in Vanguard REIT Index (VGSIX)
Building Your Market Portfolio
Five Fold Portfolio:
- 20% in Vanguard Total Stock Market Index Fund (VTSMX)
- 20% in Vanguard Inflation Protected Securities Fund (VIPSX)
- 20% in Vanguard Total International Stock Index Fund (VGTSX)
- 20% in Vanguard REIT Index (VGSIX)
- 20% in American Century International Bond Fund (BEGBX)
Six Ways From Sunday Portfolio:
- 16.65% in Vanguard Total Stock Market Index Fund (VTSMX)
- 16.65% in Vanguard Inflation Protected Securities Fund (VIPSX)
- 16.65% in Vanguard Total International Stock Index Fund (VGTSX)
- 16.65% in Vanguard REIT Index (VGSIX)
- 16.65% in American Century International Bond Fund (BEGBX)
- 16.65% in Vanguard Energy (VGENX)
But You Want More
• Not happy with getting what everyone else gets?
• More potential return means more real risk
• NOT ALL RISK IS REWARDED
– Think you can beat the pros?
– Some will win, others will lose
– Beware greed (remember Madoff?)
• Take risk knowingly, intelligently
Post Modern Portfolio Theory
• Any investment other than the market is a bet
• Bets are zero-sum propositions
• Can you beat the pros?
Post-Modern Portfolio Theory
• Divide your portfolio into two parts
• Alpha
– Percentage of your portfolio that you are willing to
“bet”
– Can be individual stocks or bonds, or funds
• Beta
– Percentage of your portfolio to invest in the
market
– Invest according to your asset allocation
– Use index funds for asset classes
Example
• Your investment objective
– You want to save for retirement
• Your risk tolerance
– You can take some risk but want to be able to
sleep at night
• Your alpha
– You believe Asian stocks will beat the market
– Willing to bet 10% of your money
Example – Your Investments
• Alpha
– Buy Asian index fund with 10% of your money
• Beta
– Asset allocation with moderate risk
– 60% stocks
• Purchase a total stock market index fund
– 35% bonds
• Purchase total bond market index fund
– 5% cash
• Purchase a money market fund
Twelve Financial Truths
Jonathon Clements, WSJ 6/18/06
1.
2.
3.
4.
It’s hard to cut back
You will never be satisfied
Borrowings have to be repaid
Fancy cars and expensive clothes are not a
sign of wealth
5. Your family could prove to be your
greatest liability
6. Investors face three enemies
1. Inflation
2. Taxes
3. Investment costs
1-23
Twelve Financial Truths
Jonathon Clements, WSJ 6/18/06
7. Adding investments can lower risk
8. Diversification is a mixed bag
9. Not all risk is rewarded
10.Most investors fail to beat the market
11.Change is costly
12.Your best investment strategy is saving
1-24
Summary
1. Determine your investment objective
2. Know your risk tolerance
3. Identify your alpha and beta
•
•
Alpha – percent you are willing to bet
Beta – percent invested in the market
4. Place your bets with your Alpha
5. Invest Beta according to asset allocation
•
Use index funds to match the market
Homework
• What investment theory do you believe?
• How will that guide your investing?
• Do you have an investment strategy?