A Simple Plan

By Scott Lummer
Chief Investment Officer, mPower

This week I'm addressing the question I've received most often over the past month. (Actually that's not entirely true. The question I have been asked most is "How did a guy as dumb as that doctor on "Survivor" actually get through medical school?" But some questions defy explanation.)

"You talk a lot about maintaining a consistent investment plan. How does one develop a plan to begin with?"

The way I start developing a plan is to focus on the general types of investments in my portfolio, called asset classes, and then choose the specific funds or securities that I will use for each type of investment.

Different advisors have different definitions of asset classes. Most find it useful to think of the investment universe as divided into five asset classes — money market funds (sometimes referred to as "cash"), bonds, large-capitalization (large-cap) stocks, small capitalization (small-cap) stocks, and international stocks.

Depending on how thorough you are, you may divide the classes into smaller and smaller groups. I know one pension plan manager who sorts his portfolio into 38 asset classes (he also spends a good part of each weekend alphabetizing his colognes).

In my view, and in the view of nearly all respectable advisors, the most important investment decision you make is what proportion of your money to invest in each asset class. This is your asset allocation. Research has indicated that asset allocation is the key to explaining why different portfolios produce different results. In other words, the decision of how much to invest in an asset class is much more important than the decision of which funds or securities you should use.

The five asset classes I mentioned can be classified into two groups — debt investments (cash and bonds) and equity investments. Deciding how much to have in each of these two groups is key, because that will strongly impact the risk of your portfolio.

I can't make this decision for you, because it depends on your personal preference for taking on risk and on your retirement date. The question I can answer, broadly, is how to allocate the portion you invest in equities. As a rule of thumb, I suggest a 60-25-15 strategy — approximately 60 percent of your equity in domestic large-company stocks, 25 percent in international stocks, and 15 percent in domestic small company stocks.

International stocks provide good diversification for when the U.S. market declines, and small-company stocks provide additional growth. However, investing too much in small stocks can create too much risk. (Remember how far small-company stocks fell in March and April?)

Now you can get fancier, if you'd like. First of all, this is America — you have the right to disagree with me. The equity allocation above is what I recommend to clients — perhaps more importantly, it's what I use for my retirement plan. But you know what? Some of my clients don't listen to me. They put 20 percent in small-cap stocks and 20 percent in international. Or, they put 65 percent in large companies and only 10 percent in small companies. My belief is that my recommendation will, over the long run, allow you to accomplish the growth you seek from stocks with minimal risk. But, asset allocation is not an exact science — I could be wrong.

The main point is that you should practice broad diversification by dividing your money across the three equity groups, and not overload your portfolio with too many risky small-company stocks.

The other way you can get fancier is by splitting the three equity categories into smaller groups. Divide the large- and small-company groups into value and growth stocks (I would suggest a slight emphasis on value). Break down international into developed country and emerging markets (but, put no more than 30 percent of international into the riskier emerging market group).

It's really difficult to talk about the correct level of risk in a column, because it is a personal choice. But, there are three things you should always keep in mind.

First, there are no guarantees. Yes, financial theory and past statistical results suggest that over a long period of time you will likely have higher returns if you invest a larger proportion of your money in stocks. But, there is no assurance that stocks will earn high returns over the next 20 years. I believe you will be better off with a large proportion in stocks (I have all of my money in equities), but risk does exist, regardless of your time horizon.

Second, even if you gain comfort over the long term, you have to be able to live with your portfolio on a day-to-day basis. One of the reasons that I have an all-equity portfolio is that I never worry about short-term movements. But, not everyone can say that. You have to know what your reaction will be to a severe market downturn before committing to a very risky portfolio.

Third, you have to look at your time to retirement (your time horizon). The longer you have until you retire, the more risk you can take. Early in your working life you have a lot more financial flexibility than you do later in your life.

Look at my situation, for example. I will not retire for another 20 years. If there were a huge market decline, I could make up for it by choosing to work longer, adjusting my retirement goals, taking a more lucrative job (pssst, boss, are you listening?), or spending less money (fewer exciting trips to Fresno and no more Eminem CDs). In my 60s, I'll have less flexibility — I won't be able to adjust my retirement date as easily, my retirement goals will be more set, the job opportunities will have passed, and I will have visited all the Fresno raisin factories. Because I will have less flexibility, I will be able to afford less risk.

Here's What to Do

I will divide up my recommendations into three groups — 20 years (or more) Before Retirement (B.R.), 10 years B.R., and one year B.R. However, you may feel these recommendations are too conservative or aggressive, depending on your attitude towards risk.

When I suggest bonds, I'm referring to short-term bonds. I am not suggesting you put anything in money markets; however, you may want to, if you decide you want very little risk and you have only a few years until retirement.

So that's the plan. Now that I've answered that question, would someone please tell me how that guy got through medical school?

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

A Simple Plan

By Scott Lummer
Chief Investment Officer, mPower

This week I'm addressing the question I've received most often over the past month. (Actually that's not entirely true. The question I have been asked most is "How did a guy as dumb as that doctor on "Survivor" actually get through medical school?" But some questions defy explanation.)

"You talk a lot about maintaining a consistent investment plan. How does one develop a plan to begin with?"

The way I start developing a plan is to focus on the general types of investments in my portfolio, called asset classes, and then choose the specific funds or securities that I will use for each type of investment.

Different advisors have different definitions of asset classes. Most find it useful to think of the investment universe as divided into five asset classes — money market funds (sometimes referred to as "cash"), bonds, large-capitalization (large-cap) stocks, small capitalization (small-cap) stocks, and international stocks.

Depending on how thorough you are, you may divide the classes into smaller and smaller groups. I know one pension plan manager who sorts his portfolio into 38 asset classes (he also spends a good part of each weekend alphabetizing his colognes).

In my view, and in the view of nearly all respectable advisors, the most important investment decision you make is what proportion of your money to invest in each asset class. This is your asset allocation. Research has indicated that asset allocation is the key to explaining why different portfolios produce different results. In other words, the decision of how much to invest in an asset class is much more important than the decision of which funds or securities you should use.

The five asset classes I mentioned can be classified into two groups — debt investments (cash and bonds) and equity investments. Deciding how much to have in each of these two groups is key, because that will strongly impact the risk of your portfolio.

I can't make this decision for you, because it depends on your personal preference for taking on risk and on your retirement date. The question I can answer, broadly, is how to allocate the portion you invest in equities. As a rule of thumb, I suggest a 60-25-15 strategy — approximately 60 percent of your equity in domestic large-company stocks, 25 percent in international stocks, and 15 percent in domestic small company stocks.

International stocks provide good diversification for when the U.S. market declines, and small-company stocks provide additional growth. However, investing too much in small stocks can create too much risk. (Remember how far small-company stocks fell in March and April?)

Now you can get fancier, if you'd like. First of all, this is America — you have the right to disagree with me. The equity allocation above is what I recommend to clients — perhaps more importantly, it's what I use for my retirement plan. But you know what? Some of my clients don't listen to me. They put 20 percent in small-cap stocks and 20 percent in international. Or, they put 65 percent in large companies and only 10 percent in small companies. My belief is that my recommendation will, over the long run, allow you to accomplish the growth you seek from stocks with minimal risk. But, asset allocation is not an exact science — I could be wrong.

The main point is that you should practice broad diversification by dividing your money across the three equity groups, and not overload your portfolio with too many risky small-company stocks.

The other way you can get fancier is by splitting the three equity categories into smaller groups. Divide the large- and small-company groups into value and growth stocks (I would suggest a slight emphasis on value). Break down international into developed country and emerging markets (but, put no more than 30 percent of international into the riskier emerging market group).

It's really difficult to talk about the correct level of risk in a column, because it is a personal choice. But, there are three things you should always keep in mind.

First, there are no guarantees. Yes, financial theory and past statistical results suggest that over a long period of time you will likely have higher returns if you invest a larger proportion of your money in stocks. But, there is no assurance that stocks will earn high returns over the next 20 years. I believe you will be better off with a large proportion in stocks (I have all of my money in equities), but risk does exist, regardless of your time horizon.

Second, even if you gain comfort over the long term, you have to be able to live with your portfolio on a day-to-day basis. One of the reasons that I have an all-equity portfolio is that I never worry about short-term movements. But, not everyone can say that. You have to know what your reaction will be to a severe market downturn before committing to a very risky portfolio.

Third, you have to look at your time to retirement (your time horizon). The longer you have until you retire, the more risk you can take. Early in your working life you have a lot more financial flexibility than you do later in your life.

Look at my situation, for example. I will not retire for another 20 years. If there were a huge market decline, I could make up for it by choosing to work longer, adjusting my retirement goals, taking a more lucrative job (pssst, boss, are you listening?), or spending less money (fewer exciting trips to Fresno and no more Eminem CDs). In my 60s, I'll have less flexibility — I won't be able to adjust my retirement date as easily, my retirement goals will be more set, the job opportunities will have passed, and I will have visited all the Fresno raisin factories. Because I will have less flexibility, I will be able to afford less risk.

Here's What to Do

I will divide up my recommendations into three groups — 20 years (or more) Before Retirement (B.R.), 10 years B.R., and one year B.R. However, you may feel these recommendations are too conservative or aggressive, depending on your attitude towards risk.

When I suggest bonds, I'm referring to short-term bonds. I am not suggesting you put anything in money markets; however, you may want to, if you decide you want very little risk and you have only a few years until retirement.

So that's the plan. Now that I've answered that question, would someone please tell me how that guy got through medical school?

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.