Sunday, 14 August 2016

A Random Walk Down Wall Street - Part Four 3: A Practical Guide for RANDOM WALKers and other Investors

Chapter 14. A life-Cycle Guide to Investing

The most important investment decision you will probably ever make concerns the balancing of asset categories (stocks, bonds, real estate, money-market securities, etc.) at different stage of your life.

I.Four Asset – allocation principles

1. History shows that risk and return are positively related.
2. The risk of investing in common stocks and bonds depends on the length of time the investments are held. The longer an investor’s holding period, the lower the risk.
a. Thus, your stage in the life cycle is a critical element in determining the allocation of your assets.
b. A substantial amount (but not all) of the risk of common stock investment can be eliminated by adopting a program of long-term ownership and sticking to it through thick and think (the buy-and hold strategy).
c. The longer an individual’s investment horizon, the more likely it is that stocks will outperform bonds. Over any single-year period, there is a one-out-of-three chance that bonds or money-market funds will outperform stocks. But if one looks instead at different twenty or twenty-five-year holding periods, stocks are the performance winners every time. These data support the advice that younger people should have a larger proportion of their assets in stocks than older people.

Total Annual Returns for Basic Asset Classes, 1926-2001
Average Annual Return      Risk Index (year-to-year volatility of Returns)
Small company common stocks
12.1%     35.3%
Large company common stocks
10.4        20.8
Long-term corporate bonds
5.4          8.6
U.S. Treasury bills
3.7          3.4

3. Dollar-cost averaging can be a useful, though controversial, technique to reduce the risk of stock and bond investment.
a. It means investing the same fixed amount of money in, for example, the shares of some mutual funds at regular intervals, say, every month, over a long period of time. It works because you bought more shares when they were cheap and fewer when they were dear.
b. A critical feature of the plan is that you have both the cash and the courage to continue to invest during bear markets as regularly as you do in better periods.
c. One potential drawback to dollar-cost average is that brokerage commissions are relatively high on small purchases. Thus, it is usually advisable to buy larger blocks of securities over longer time intervals. For example, it is cheaper to buy $150 worth of stock each quarter, or $300 semi-annually, than to invest $50 each month. If you pick a no-load mutual fund, this problem disappears. You can invest as little as $50 per month in most no-load funds, with no brokerage charges at all.
4. You must distinguish between your attitude toward and your capacity for risk.
a. A is a recently widowed 65 year old. B is a single 26 year old, just out of MBA program of Harvard.
b. A cannot work any more because of severe arthritis. Apart from monthly Social Security payments, all A has to live on are the earnings on a $250,000 group insurance policy of which she is the beneficiary and a $50,000 portfolio of small-growth stocks. A’s capacity to bear risk is severely constrained by her financial situation. She has neither the life expectancy nor the physical ability to earn income outside her portfolio. A portfolio of safe investments that can generate substantial income is what is appropriate for A. Bonds and high-dividend-paying stocks as from an index funds of real estate investment trusts are the kinds of investments that are suitable.
c. B has both the life expectancy and the earning power to maintain her standard of living in the face of any financial loss. Therefore, A’s portfolio of small-growth stocks would be far more appropriate for B
than for A.

II. Three guidelines to tailoring a life-cycle investment plan
1. A specific need must be funded with specific assets dedicated to that need: if you expect to need a $30,000 down payment to buy a house in one year. That $30,000 to meet a specific need should be invested in a safe security, maturing when the money is required, such as a one-year certificate of deposit.
2. Recognize your tolerance for risk (P346).
3. Persistent saving in regular amounts, no matter how small, pays off: you need to pick no-load mutual funds to accumulate your nest egg because direct investments of small sums of money would be prohibitively expensive. Also, mutual funds permit automatic reinvestment of interest, or dividends and capital gains.

III. The life-cycle investment guide
Please refer to the chart!

a. For those in their twenties, a very aggressive investment portfolio is recommended. The portfolio is not only heavy in common stocks but also contains a substantial proportion of international stocks including the higher risk emerging markets.
b. As investors age, they should start cutting back on riskier investments and start increasing the proportion of the portfolio committed to bonds and stocks that pay generous dividends such as REITs. By the age of 55, investors should start thinking about the transition to retirement and moving the portfolio toward income production. The proportion of bonds increases and the stock portfolio becomes more conservative and income-producing and less growth-oriented. In retirement, a portfolio heavily weighted in a variety of bonds is recommended. Nevertheless, even in one’s late sixties, 25% of the portfolio is committed to regular stocks and 15% to real estate equities (REITs) to give some income growth to cope with inflation.
c. For most people, I recommend broad-based total stock-market index funds rather than individual stocks for portfolio formation. Do make sure that any mutual funds you buy are truly “no-load” and pick safer, income-producing funds later in life.
d. Everyone should attempt to own his or her own home. I believe everyone should have substantial real estate holdings and, therefore, some part of one’s equity holdings should be in REIT index mutual

A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel

No comments: