Planning your Investment

The first step you should do before thinking about investment is to educate yourself on investing basics. There are several books that do not require difficult math knowledge, or finance know-how.

After educating yourself, you will need an investment plan that includes your desired asset allocation. Your investment plan should look out into the future and include things like a new home purchase in a few years, education expenses for children, and retirement, just to name a few. All of these goals require money in different time frames, and the money should be invested accordingly. Studies have shown that your asset allocation will determine more than 90% of your portfolio return, so you should focus on your asset allocation first rather than on fund selection.

Since risk and return are directly related, your asset allocation should balance your need to take risk with your ability to withstand the ups and downs of the market. Your “Need” can be determined in a lot of ways. If you are young, you have the benefit of many years of compounding, so your need to take risk is low. On the other hand, your portfolio size is probably small, leaving you with a long way to go to reach your retirement goals. As a result, you could argue that your need to take risk is high.

For those investors who are closer to retirement, it may be possible to more closely determine need. First, estimate approximately how much income you will need annually after retirement. For this example, we’ll assume you need $100,000 per year. Next, look at any pensions or social security benefits that will provide a source of income. If a pension provides $30,000 per year and social security provides an additional $20,000 per year, then your portfolio would need to provide an extra $50,000 each year. To prevent running out of money, you should probably start by withdrawing 4% a year or less with an annual inflation adjustment. To generate $50,000 per year at 4% requires a minimum portfolio size of $1,250,000. How close are you to your goal?

Turning to ability, this relates to your ability to withstand the ups and downs of the market without getting nervous and making changes to your asset allocation. Selling in the face of a decline is about the worst thing you can do. Check out this table by Larry Swedroe, based on the 1970s bear market, showing the amount of decline for various stock/bond allocations:

Max Equity - Exposure Max loss

20%...............5%

30%..............10%

40%..............15%

50%..............20%

60%..............25%

70%..............30%

80%..............35%

90%..............40%

100%.............50%

There are other ways to determine an asset allocation, including several rules of thumb:

•           Your age in bonds. So, if you are 40 years old, then use a 60/40 (equity/bond) allocation.

•           110 minus your age = equities (110-40 yrs old=70/30 asset allocation)

•           120 minus your age = equities (120-40 yrs old = 80/20 asset allocation)

•            Vanguard can also help you create an Investment Plan and can make an investment recommendation.