Wednesday, July 6, 2016

An Age Appropriate Balance

The subject keeps coming up in conversations so pardon me if this is something you have already seen more than one time. People frequently ask me what investments they should buy. Of course, since my crystal ball didn’t come with a set of instructions, I won’t suggest what to buy with specific recommendations, but I will suggest how to buy and a few rules of thumb to keep you out of trouble.

The old rule of thumb was your age in bonds. Bonds are here defined as cash, savings accounts, certificates of deposit, money market funds, bonds, and bond mutual funds. Equities, the other half of the equation would consists of individual shares including common stock, preferred stock, Real Estate Investment Trusts, Master Limited Partnerships (oil and gas pipelines) and mutual funds containing various forms of these equities.

Hence at age 30, an investor should have 30% in bonds and 70% in stocks.
At age 70, an investor should have 70% in bonds and 30% in stocks.

There are two reasons that this was accepted common wisdom. When you are young, you are playing with small amounts of money over a very long time period—the rest of your working life and beyond. When you are old you are (hopefully) dealing with large sums of money over a limited time—the rest of your life. Since you can’t easily go back to work at age 80 and start over, you can’t afford to make a big mistake at such an advanced age.

The second reason is—reason. Our decision making capacity peaks around age 55, then we start downhill.

Following the wretched stagflation of the 1970s, the conventional wisdom was changed to allow for the threat of inflation. First it was suggested your age less 10% in bonds. Then it went to your age less 15% in bonds during the go-go years leading up to the slow motion train wreck of 2006 to 2009.

Using this logic, at age 30 an investor should have 15% in bonds and 85% in stocks.
At age 70, an investor should have 55% in bonds and 45% in stock.

Since 2008, convention wisdom has been creeping back to something closer to the original suggestion of your age in bonds. If you stay within 5% or 10% of the old conventional wisdom, chances are you will be alright.

What about gold? Is it money or is it a stock? I change my mind on this question from time to time. Right now I consider gold money since the Chinese and the Indians consider it money. I still think the best advice I have heard on gold suggests, “Put 5% of your portfolio in gold (shares in GLD is the simplest method). Then pray every day that the value of your gold declines. If the value of your gold is declining, it is likely that the value of everything else is going up.” I think that 5% is a little on the high side, but I agree that every portfolio should contain some precious metal as insurance against a market collapse. The changing value of gold is a measure of fear in the marketplace. When everyone is optimistic and happy, the value of gold drops. When we worry about Brexit or are reacting to some other threat to the economy the price of gold goes up.

There are other considerations. What kind of bonds? What kind of stocks? While this question is beyond the scope of a single blog post, more in conservative positions and less in risky positions when you are old and the reverse when you are young. Hence a young person can afford to have more in small cap stocks, technologies, and developing markets. The old timer should have the bulk of his equity holdings in stable large cap stocks from the developed world along with shares in regulated utilities and consumer non-cyclicals that sell things people always need, like food, soap, and toilet paper.

The same logic applies to bonds. The safest are Treasury bonds and similar “full faith and credit” instruments issued by the Federal Government. Investment grade bonds from companies like Chevron, General Electric, and regulated utilities would come next. Junk bonds, euphemistically termed “high yield” are risky, but if you buy one from a company that works itself out of trouble, you can make a lot of money. Of course, if the company defaults, all you are left with is a worthless piece of paper.

Finally, let me mention diversification. If you have more than 7% to 10% of your net worth in any single company or even in a few closely related companies in the same sector you are asking for trouble. British Petroleum was one of the best managed, most profitable companies in the world, until a black oily swan flew over a drilling platform in the Gulf of Mexico. Then British Petroleum lost half its value in a couple of weeks. People, who held less than 10% in dotcoms in the years before 2000, didn’t make as much money as their friends who believed the most dangerous words in investing, “This time it’s different,” but then in 2000 when they watched their dotcoms fade into the sunset, they just shrugged their shoulders and moved on. Those who believed that this time it was different lost almost everything.

If the foundation of your investment portfolio contains shares in several low cost index funds representing different types of investment vehicles, you should be sufficiently diversified.

Good luck. And Please! Let’s be careful out there.

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