Tuesday, March 26, 2013

Diversification Distribution and Age

Yesterday, I threw out a sample portfolio made up of low cost index funds for someone in his early sixties. Like me, it is pretty conservative. It has been a while since I have visited the subject of diversification as a function of age, so let’s go over the basics one more time.

The old conventional wisdom recommended, “Your age in bonds.” That is at thirty years of age an investor should have 30% of their investments in bonds and 70% in stocks. At 60 and investor should have 60% of their holdings in bonds and 40% in stocks.

The new conventional wisdom states that due to the risk of inflation, the amount held in stocks should be bumped by 15%. Hence at thirty an investor should have 85% of their money in stocks and only 15% in bonds; at sixty that would be 55% in stocks and 45% in bonds.

Personally I have decided that for now I will allow my stock holdings to float between 40% and 55%. Hopefully, I will move toward the lower end of the range when I think stocks are too high and towards the higher end of this range when I believe stocks to be undervalued. If I had to pick one all purpose target allocation for my age it would be 50% in stocks and precious metal and 50% in bonds, money market funds, and CDs.

I have debated whether gold (a commodity) should be considered cash or a stock in this calculation since it neither. I have concluded since its values goes up and down independent of the valuation of the American Dollar, it behaves more like a stock than a cash type investment. Therefore, I throw it in with my stocks. By the way my holdings in precious metals are closer to 2.5% than the 5% I proposed in my sample portfolio.

There are three reasons to invest growth, income, and capital preservation. These goals are interwoven with time. When a young person is in his or her twenties and early thirties growth is everything. Since this is the age of household formation most of a young family’s money is going to buy a house, furniture, and baby clothes. Most likely their only investments will be a 401K and/or a Roth IRA. This is long range money that will not be touched for thirty or forty years. Since the amounts are small and the time frame long, young investors can take greater risks than older investors.

As the investor passes 35, moving towards middle age capital preservation becomes more of an issue. If a 50 year old investor was 100% in stocks in 2008, he would have lost almost half his money with only 15 years to rebuild his accounts before retirement. It is very difficult to recover from such a disaster. If he held half of his money in bonds and cash, he would only have lost 25% of his money. He would be able to use that cash reserve to buy more stocks at bargain basement prices. Today not only would his initial investment been restored to its 2008 level but the new shares he bought at the bottom could have doubled in value.

When an investor finally reaches retirement, there is a new need, income. If he even has a pension, it won’t come close to matching his preretirement income. The difference will come from income generated by his portfolio or from expending the capital he has built over a lifetime. Today the Federal Reserve Bank is punishing savers with its zero interest rate policy. It is very difficult to generate income without increasing risk. Older investors are moving out of bonds that pay little or nothing into riskier investments in dividend paying stocks in search of income. This is dangerous because capital preservation after retirement is of paramount importance since there is no income to rebuild a portfolio after a crash.

In extreme old age, capital preservation is everything. If an investor has been blessed with both a long life and the financial resources necessary to have made that a good life, it is unlikely that she will outlive her money unless she takes unnecessary risks. If an investor is 87 and in reasonable health, how many years worth of capital could she need? The Government would suggest this woman or her agent with durable power of attorney plan for 5.87 years.

Then God, government, and your heirs can fight over what is left.

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