Investing for all stages of life

Posted on 02.08.07 by Afzal Adamjee @ 12:03 pm    

“Even if you’re on the right track, “you’ll get run over if you just sit there”, said cowboy humorist Will Rogers. As an investor, you want to make progress. To succeed, you need to know:

1. Where you are headed, and;

2. What’s the best way to get ahead?

Your answers will change accordingly. It is true that nothing is constant in finance. The stock market moves up and down, interest rates rise and fall, mutual fund portfolio managers come and go. Most predictably, you get older. The right portfolio of investments when you’re 25 won’t be the right portfolio when you’re 45 with kids in college, or 65 and ready to retire.

Your portfolio

In this changing world, you should review your investments at least twice a year, every year. Some people do it on their birthdays, some at tax time, some at year’s end. Pick times you won’t forget. And don’t put it off - what could be more important to you and your family!? If your investments are doing well, you’ll enjoy the review. If they’re not doing so well, all the more reason to think about changing them.

Some investment review topics are obvious. Have you gained money or lost it? Are you beating the market or not? Compare your investments to their value at your last review and to the various Index figures at both times. More complicated, but vital to staying on the right track, is reviewing what Stock Exchanges call asset allocation. Asset allocation, the strategy of investment, describes how you divide your money among the three basic investment categories:

1. Cash (savings accounts, bank certificates of deposit [CDs], money market funds)

2. Mutual Funds

3. Growth (usually stocks)

Putting these together in the specific combination that is best for you - that’s what asset allocation is all about. What’s best for you depends on the amount of risk you want to take, which in turn depends on how old you are, what your goals are, and your personal wealth. But first let’s look at the categories.

Cash you can count on

In the investment world, cash is not just a pile of quarters or Rs. 1000 note. It also includes savings accounts, bank certificates of deposit (CDs) and money market funds, basically anything that is liquid. Savings accounts and CDs pay a rate of interest. Money market funds are investments, purchases of short-term, high-quality, interest-paying securities. They pay a higher rate of interest than savings accounts and usually a higher rate than CDs. Compared to stocks or bonds, money market funds are safe and stable. The potential return on your investment is lower, but so is the risk.

To an investor, cash has several advantages. It offers stability amid other changes. It is easily available and so can meet short-term needs. It is an emergency nest egg. On the other hand, cash grows more slowly than other investments can. If inflation strikes, cash can actually lose value in comparison to rising prices.

Before investing in stocks or bonds, you should have enough savings in cash to live on for six months. Don’t invest this cash in other asset categories. You may need a reserve if you lose your job, your hours are cut back, you encounter health issues, you have a baby, or you need to care for someone else in your family.

Mutual Funds

According to the theory of contrary opinion, it makes sense to go against the crowd because the crowd is generally wrong. Based on this theory, several indicators have been developed. One of them reflects mutual fund liquidity.

If mutual fund liquidity is low, it means that mutual funds are bullish. So contrarians argue that the market is at, or near, a peak and hence is likely to decline. Thus, low mutual fund liquidity is considered as a bearish indicator. Conversely when the mutual fund liquidity is high, it means that mutual funds are bearish. So contrarians believe that the market is at, or near, a bottom and hence is poised to rise. Thus, high mutual fund liquidity is considered as a bullish indication.

Your stock in trade

Stocks, also called equities, represent shared ownership of a company. When you buy stock, you join other owners. Stocks can make money in two ways: dividends and resale value. A company may reward its owners with a distribution of profits, calculated as an amount per share of stock, if the price of stock goes up, investors can make a profit by selling the stock for more than they paid for it.

Because stocks can increase in value freely and quickly, they offer a greater chance of significant investment growth than cash or mutual funds do. Stock prices tend to rise with inflation and so buffer its effects. Stocks in a company that pays relatively large dividends also provide returns on investment without resale. But stocks are far more vulnerable to risk than cash or mutual funds. Stock prices fluctuate in reaction to news about a company’s financial well-being or its potential for growth. Owning a range of stocks, as in a mutual fund, limits dependence on one company’s success. Stock prices also fluctuate in response to the general economic climate, however. You can lose money in stocks.

Allocating your assets

The ideal, of course, is to combine these three asset classes so as to protect your nest egg while helping it grow. The reason you need to review your asset allocation frequently is that each investment performs differently at any one time. For example, when interest rates are high, cash assets offer high yields, but stocks tend to lag. As you’d expect, the reverse is also true.

Adjusting your mix of investments will improve your long-term return while keeping your risk of loss to a minimum. For asset allocation to work, your investments must also be diversified within each category, so your portfolio doesn’t get into trouble if the financial waters become choppy.

Your asset allocation should be based on four factors:

1. The amount of time you have to reach your financial goals

2. The type of goals you have

3. Your tolerance for risk

4. Your personal wealth

Aggressive investors with long-term goals will want more stocks in their portfolio, while more conservative investors will want more bonds. All investors will need some cash, to meet short-term needs and to provide an emergency nest egg. If you have time to seek maximum growth, and to accept risk along the way, you might allocate 65 percent to stocks, 30 percent to mutual fund, and 5 percent to cash. With less time, or less tolerance for risk, a more conservative allocation would put 55 percent in stocks, 40 percent in mutual fund, and 15 percent in cash.

Aggressive investors typically look for high-growth stocks, including stocks of companies in other countries. Conservative investors focus on cash, mutual fund, and stocks of large, well-known companies. These stocks are called blue chips because of their consistently high performance.

Ministering to your portfolio

Your twice-yearly review of your portfolio is not the only time you should look at your investments. A number of events could trigger a reallocation of your portfolio.

Your life changes

Reconsider your asset allocation when you get married, have a baby, buy a house, change jobs, inherit money, encounter serious health problems, divorce, or retire—and that’s just a partial list.

The economy changes

Reconsider your asset allocation when interest rates or stock prices move dramatically, layoffs rise, businesses close, people suddenly make fortunes, or the news is full of stories about the economy.

An asset changes

Reconsider your asset allocation when a mutual fund’s performance keeps lagging, a company merges or changes managers, a mutual fund portfolio manager leaves, or you change stockbrokers or financial advisers.

Investing for life: four stages

These rules of thumb should be used as guidelines when discussing your investments with a financial planner.

Starting out: under 30

Because you probably have no dependents, and you have plenty of time to recoup any temporary losses, you can invest aggressively at this stage of your life. Suggestion: 60 percent in solid growth stocks or growth stock funds, 20 percent in aggressive growth stocks or growth stock funds, 10 percent in growth-and-income funds, 5 percent in mutual fund, and 5 percent in a money market fund. Thirty-something

If you have a child or children, you need some liquidity for all the adventures that come with growing up, while you save toward their college tuition. Suggestion: 40 percent in growth stocks, 30 percent in growth-and-income stock funds, 20 percent in mutual fund, and 10 percent in a money market fund. Middle age: heading for 50

If you’re paying college tuition, you probably have less to invest. Suggestion: 50 percent in growth stocks, 20 percent in aggressive growth stocks, 20 percent in growth-and-income stocks, and 10 percent in a money market fund. Ready to retire? The second half-century

You may be an empty-nester at this point, with your children getting out of college and starting work. Your goal is to accumulate money for retirement. Suggestion: 40 percent in growth stock funds, 25 percent in growth-and-income stock funds, 15 percent in corporate bonds, 10 percent in Treasury notes, and 10 percent in a money market fund. What do you think?