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Hello Fools.

My wife and I are expecting our first child, and I've suddenly become more serious about retirement planning. Specifically, how to effectively diversify our investments.

We've been saving for a while, but I had never given much thought to diversification. Recently I've been doing some reading on asset allocation and MPT, and I've got some questions for you veterans.

Not necessarily looking for answers, as there may not be any. Any thoughts, links to additional resources, etc are appreciated.

1- In my readings on MPT, and specifically around using correlation to diversify your assets, I've encountered 2 big pieces of criticism: 1) In an economic crisis, the correlation of all asset classes moves to 1 (and they all go down to the drain). 2) Many correlation models use a standard distribution, while the distribution of investment returns is typically anything buy standard.

How do you all address the above 2 issues when determining your asset mix?

2- In terms of asset classes, it seems like there are a million levels of classification that one could use. A true newbie could just use "stocks, bonds, RE and cash" as their 4 classes. Then you get into "Large cap, small cap, etc" at the next level, and this can continue on and on identifying more minute levels of difference (e.g. - TMF touts 12 different asset classes in it's Rule Your Retirement program)

What's the "right" level to draw the line among asset classes?

Again, I know there may not be answers. Any thoughts are appreciated.

-CH
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The link below is to Rick Ferri's blog site. Rick is a CFA and has written six investment books. The blog linked to below is titled: "How to Choose Egg Baskets"

http://www.rickferri.com/blog/investments/how-to-choose-egg-...

-drip
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You may find this link of portfolio returns interesting:
http://www.retireearlyhomepage.com/reallife11.html
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You will find the author of this study [intercst] hangs out at this board:
http://boards.fool.com/retire-early-liberal-edition-118222.a...
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I'm going to take a somewhat different tack and ask if you have written down a plan that identifies where you want to be in retirement. No, not a physical location, but rather a financial position that allows you to be the person you want to be.

Do you need a retirement income of $40,000 year vs. 60K vs. 100K?

If you know your goal ... then the vehicle to get you there becomes more easily identified.

When I say 'written down", I don't mean a 15 minute, off the top of your head 'spoof'. I mean a thoughtful, 18 month effort.

In part... this is a plan for your life.

I recommend Stephen Covey's "First Things First"... (do NOT read it for the 'executive time management' focus, but rather, read it for the life plan focus).

http://www.amazon.com/Things-Merrrill-Rebecca-Merrill-Stephe...


be well :-)
ralph
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One of the problems with trying to implement your asset allocation based on modern portfolio theory is that the correlation between asset classes is constantly changing which means that the optimal strategy is also always changing. When you look at the nice long term MPT charts seem to show a clear strategy, but when you look at this by decade the optimal strategy is different for each decade.

I can't link to it directly but the link below will take you to the Amazon "look inside" search for Richard Ferri's book "All About Asset Allocation".

http://www.amazon.com/All-About-Asset-Allocation-Second/dp/0...

in this search on the phrase;

"diversification benefit over the decades"

Then on the left side of the screen select Page 59, figure 3-10


This shows how the chart is all over the place when graphed by decade. This doesn't mean that MPT is useless, but to me a least it instead of showing and absolute best strategy it instead shows more a general style of how and why to mix your asset classes.


Greg
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Things change - sometimes important things that you do not have any control over. One example my parents never figured on medicare during their working years. Tax rates and what is taxed will change.

I am guessing you are at least 25 years from retirement and it may be longer. Here is something you can use as a target for now. Assume you withdraw 4% of your investments. So if you want 40K in retirement income you need $1 million. Next determine what you are going to spend. This sounds so simple, but it is complex. When we retired, taxes went down - so income taxes dropped, Social Security and Medicare taxes ended. We stopped adding funds to our retirement fund and started pulling funds out.

Some people look at retirement as an opportunity to travel and do things they put off while working. Changes like this will increase spending. The things like medicare costs, auto insurance, utilities are easy to estimate and you can be wrong. I suggest you get a copy of Quicken and keep track of your spending. I don't see the need to account for every single penny, but if "Unaccounted" is more than 0.5%, I would wonder about projections.

When you are in the range of 10 years from retirement, you can fine turn things. That may mean more or less savings.

Do not under estimate the impact of not having a mortgage. While many view a mortgage payment as "rent" - you need income to cover that monthly expense. And unless those funds to pay the mortgage are coming from a Roth IRA or some other tax free source, you will have to pay income tax with the mortgage payment.

Gordon
Atlanta
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First off, thanks to everyone for the input. I'm consolidating replies into one post:

The link below is to Rick Ferri's blog site. Rick is a CFA and has written six investment books. The blog linked to below is titled: "How to Choose Egg Baskets"

---

I can't link to it directly but the link below will take you to the Amazon "look inside" search for Richard Ferri's book "All About Asset Allocation".

Very informative. I've done a cursory review but plan to do a more in-depth review this week. Thanks guys.

One of the problems with trying to implement your asset allocation based on modern portfolio theory is that the correlation between asset classes is constantly changing which means that the optimal strategy is also always changing. When you look at the nice long term MPT charts seem to show a clear strategy, but when you look at this by decade the optimal strategy is different for each decade...

This shows how the chart is all over the place when graphed by decade. This doesn't mean that MPT is useless, but to me a least it instead of showing and absolute best strategy it instead shows more a general style of how and why to mix your asset classes


Agree with this. What kinds of strategies do you use to hone in on proper allocation?

Do you need a retirement income of $40,000 year vs. 60K vs. 100K?

If you know your goal ... then the vehicle to get you there becomes more easily identified.

When I say 'written down", I don't mean a 15 minute, off the top of your head 'spoof'. I mean a thoughtful, 18 month effort.


I've got a target that was arrived at with analysis that falls somewhere between "15 minutes" and "18 months". I do plan to continue to refine this work.

I am guessing you are at least 25 years from retirement and it may be longer.

Correct. Probably around 30 years, if you average me and my wife.

I suggest you get a copy of Quicken and keep track of your spending. I don't see the need to account for every single penny, but if "Unaccounted" is more than 0.5%, I would wonder about projections.

I started doing this in January. Once I have a full year of data, I plan to use it to refine our savings goal, as mentioned above.

Thanks again.

-CH
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Also, I found this page through the Ferri blog post: http://www.bogleheads.org/wiki/Lazy_Portfolios#Core_four_por...

Seems to be a good starting place to research various allocations, especially if you're a couch potato investor (such as myself).

Thought others might be interested.
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...This shows how the chart is all over the place when graphed by decade. This doesn't mean that MPT is useless, but to me a least it instead of showing and absolute best strategy it instead shows more a general style of how and why to mix your asset classes

Agree with this. What kinds of strategies do you use to hone in on proper allocation?....


The ideal strategy is unknowable so the best you can reliably do is to make sure that you don't have a clearly bad asset allocation.

Realistically the old rules of thumb about having your age in bonds and 20% in international stocks is probably in the right ballpark and a good starting point. You could adjust the numbers by maybe 10 or 20 percent because of your preferences and analysis of the current situations and even if you are not right, that would not be far enough off to make it a catastrophically bad choice. Even if you do make a less than theoretically ideal choice, then you still have about a 50% chance of getting lucky and having the wrong choice turn out to be the right choice just by dumb luck.

Personally I am greatly underweighting long bonds in my portfolio because the low interest rates and the risk of a loss if interest rates rise, which I suspect is pretty likely at least over the next 20 years or so. I have substituted a TIPS mutual fund for these that have an intermediate duration.

I do try to set up my plans have a lot of margin of safety so that I will still be OK is some of my estimates are off;

For example I try to plan so;

1) I have enough for a budget a pretty comfortable lifestyle in retirement, nothing lavish but if my yearly retirement income ends up being a third or so short, then I still wouldn't have to worry about starving.

2) I budget to try to be able to retire at around the age of 60 to 62. If I fall short I can work a few more years.

3) I plan be able to be able to be financially independent until at least the age of 95. The odds are that I won't live that long, but if my retirement money falls short the "good" news is that I still might not actually outlive my money.


For me to get into a lot of trouble I would have to have my investments greately underperform, not be able to make it up by working a bit more, and get lucky in the logevity lottery. That is a pretty long shot and I am just as likley to have things turn out better than planned for and be able to retire a few years earelier, live a fancier lifestyle, and not outlive my money.

Greg
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First thought - lets start with the basic building block of asset classes. There are 4 or 5 based on the broad definitions.

Cash/Cash Equivalent,
Equity/Stocks,
Debt/Bonds,
Real Estate,
Commodities.

Some put RE and commodities in the same bucket and some pull precious metals out of commoditites (but leave base metals in - go figure) But, this is the universe. There are hybrids but basically this is it.

Lets look at this with a little biological taxonomy - Class as mentioned above. Then we have Order, for that I would suggest Domestic Market, Developed Market, Growth Market, and Emerging Market. To keep along this line.

Class = Asset Class above
Order = Market
Family = Sector
Genus = Style Box (cap and value)
Species = Company

At each level there are different characteristics to consider.

Lets start with everything in Equities:

rainphakir makes the point, where do you want to be and where are you now helps with determining the class. Along the lines of risk tolerance, if you know you already have what you need, then you are in preservation mode.. Probably lean more toward Debt and Cash & CE (cash equivalent) I am not a fan of the age in bonds or anything related, that is more of a risk based decision. Age may play into risk but the risk may be vastly different based on balance sheet and income.

If you are in the median range you want to be in the markets and add some risk then you are in the invested category.

You are in the early years of investing and have a light balance sheet so you probably have more risk tolerance which will then lean toward Commodities and Real Estate and being lets call it aggressive. So pulling some numbers out of the hat.

Preserve Invested Aggressive
Cash 25% 10% 0%
Bonds 60% 15% 5%
Equities 15% 50% 60%
RE 10% 15% 20%
Commodities 0% 10% 15%


Now any one of these number can change based on vies you have. IF you are in preservation and believe gold is better than sliced bread, take some out of bonds or equities and put it there. IF you like RE well, a little extra from something you dont like. Or, perhaps you beleive that dividend equities (T, P&G, SO) are just as good as bonds, well you get the idea..

That is perhaps a way you can look at the asset classes.. the pie split up because of risk return characteristics

Then start to think about "diversification" Do you put it all in the US, or tim's mother land (Can a something!) Broadly the overall markets are fairly correlated but plot out some ETF's and get a sense for yourself. This is not just the equities. Debt crosses border, RE, and commodities can be targeted toward different markets. Or Currency!!

So if aggreesive
60% Equity, 35% US, 15% Developed, 5% Growth, 5% Emerging
20% RE, 15% US, 5% Developed, a pinch?? over here
15% Comm. 10% US, 5% Developed,

Next in the steps adds a little more diversification, Family = Sector! But lets face it, if technology stocks are suffering in the US, they are probably suffering in the developed markets. There are a couple of ways to divy up the sectors, and depending on risks you can go from Utilities to Technology. I think this is a bigger building block of diversification than the style box which is next.

35% US, ~4% in nine sectors or underweight ones you dont like and overweight ones you do..

Once you have the sectors mapped out, think about Genus = Style, if you are a value investor (large cap Value) or if you subscribe to Hidden Gems (small cap growth) and how much you want to put in this. The last two may go hand in hand Style and Company (species)

4% in consumer discretionary and you are large value - Which brings us to the final level - the species, the company and here is where the diversification takes place. By the time you have got down here you are putting diversification in the forefront..

Consumer discretionary think about YUM and McDonalds.. Seems like the same, but think about, American Eagle Outfitters, Disney and McDonalds.. all "discretionary" but a little different.

Beauty is you can stop drilling down whenever you want.

ETF for total market, or
ETF for US, Foreign, Emerging
ETF for Sectors
ETF for Style

This post is already long enough - but perhaps something to consider!

d(5 asset classes)/dT











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