The Financial Philosopher

Reader Response: Balancing 'Safety' & Growth

"The best and safest thing is to keep a balance in your life, acknowledge the great powers around us and in us.  If you can do that, and live that way, you are really a wise man." ~ Euripides

I recently put forth the offer to respond to specific questions from you (the readers) regarding investing and personal finance.  A recent question from a reader addresses several common concerns regarding the balance of achieving "safety" and "growth" in a retirement portfolio.  Here's the question:

I read your article on where to invest in 2008, boomers, etc. with more than a little interest.  But, as a boomer planning to retire in less than 7 years, who just happens to be concerned about the impending recession/depression everyone is warning about... where does a near retirement boomer find safety and growth in short-term investments?

First, I'll restate the reader's main points to establish my assumptions:

• Retiring in less than 7 years:  You are a long-term (more than 10 years) investor with intermediate-term (5 to 10 years) income needs.  In other words, you will only begin withdrawing assets from your portfolio in 7 years but will need it to "outlast" you, which makes your actual investment time horizon up to 30 years. 
• Concerned about impending recession: You likely have low to moderate tolerance for risk and should allocate your portfolio accordingly.  Ideally, an investment portfolio is constructed in a way that will minimize concern over short-term "noise" -- no matter what the market direction, economic condition, or level of volatility that exists.  There are also behavioral and emotional undertones attached to this concern, which I will also address...
• Looking for "safety" and growth:  Of course, it is impossible to have "safety" and growth, in absolute terms, at the same time.  Even in the most favorable of market conditions, there is nothing "safe" that also achieves true "growth," which requires, at a minimum, returns above the rate of inflation.  An investor must, therefore, strike a balance between the amount of risk that can be tolerated (risk tolerance) and the desire to outpace inflation (historically about 3.5%).  In other words, we want to assume the highest amount of risk we can tolerate to achieve a reasonable return on our investment.

As you may guess, I believe most, if not all, investor behavior is rooted in emotion and not in logic; therefore, we should create an asset allocation balancing the reader's desire for "safety and growth" and consider human emotion by separating the two objectives (at least in our mind); to create separate perceptions and separate emotions attached to each.

I suggest viewing your portfolio as two "baskets:" The "safety" portion we will call the "intermediate-term basket," which, based on your comment, you will not need to touch for up to 7 years.  If the market gets slammed over the coming weeks, months or even a few years, then we can rest at night knowing that the "safety basket" is intact.  The "growth" portion will be your "long-term basket" that you won't touch for 10 years or beyond.    For any real "short-term" needs less than three years, you should consider as "emergency funds" and hold strictly in a liquid account.

Before considering allocation, I suggest gaining some perspective and bring perception more in line with reality with some basic findings supported by Jeremy Siegel's highly acclaimed book, Stocks For The Long Run:

• On an annual basis, stocks out-perform bonds a little less than two-thirds of the time.  That's not bad odds -- even for the risk-averse.
• For five-year periods, stocks trump bonds nearly three-fourths of the time.
• For twenty-year periods, it's nearly 95 percent and the odds continue to move in favor of stocks and finally reaches 100% out-performance at 30 years and beyond.

As for specifics, your allocation depends on many variables, such as the types of accounts (taxable, tax-deferred) and your risk capacity (portfolio size, job security, health issues).  Some readers may gain some insight with my Where to Invest 2008 series of posts.

Beyond that, there is no such thing as a "one-size fits all" allocation, so here are a few more pointers to consider:

• If your risk tolerance is moderate to moderately low, then you may try an allocation of 60 percent stocks, 20 percent bonds, 20 percent money market. 
• Safety is a relative term.  The reader expressed concern over the "impending recession." Investors may find relative safety in money market funds, high credit quality bonds and bond funds (look for credit ratings of 'A' or higher), and large company domestic stock and stock funds (I like S&P 500 Index Funds and  ETFs). 
• Bonds and bond funds generate income, which means they also generate income tax.  Keep bonds in a tax-deferred account such as an IRA. 
• Taxable accounts, especially approaching and in retirement, should hold tax-free money market funds and tax-efficient stock funds, such as index funds or ETFs.  This will keep income tax and capital distributions to a minimum.
• If you have a taxable account, such as a regular brokerage account, a strategy that may be suitable for you is to keep five years worth of retirement income in a high-yielding money market fund and the remainder of your tax-deferred (IRA, 401k) money in stocks or stock funds.  That way, you'll allow long-term assets to grow untouched and compounding interest while your short-term needs will be met at retirement without the risk of liquidating your stocks or stock funds in a downturn (remember your five-year odds in the Jeremy Siegel bullet point above). 
• Try not to concern yourself with things you can not control, such as stock market movements, economic cycles, and the "media noise" reporting on them.  This will only cause stress and more temptation to make changes in your accounts.
• Focus on things you can control, such as savings rate, asset allocation, and investment selection.
• This is certainly not a character attack but a simple fact:  Most investors have difficulty separating perception from reality and removing emotion from what is best served by logic.  Consider using a "fee-only" financial planner with a strong background in investments.  Their client-centered nature and fiduciary standard of care will provide little or no bias to investment products and little or no emotion in managing your money.   

As you may have noticed, a secondary theme has emerged in this post and that is the question of who is best suited to manage your money... Would you recommend you as an investment advisor to someone else?  If not, then why would you use you?  Do you really want to manage your assets?  Do you have the passion and capacity required for successful investing and personal finance?  Are there other things you would rather spend your time on than your money?  How much does it "cost," in terms of time and missed opportunities, to manage your money?

The "do it yourself" mantra is overly hyped by people and entities trying to sell advertising or their latest book.  The best "advice" I can give is to do what is necessary to enjoy your life by staying true to the fundamentals of self-acquaintance, simplicity, moderation, and balance... 

TFPAuthor, Kent N. Thune, QPFC, is the President and founder of Atlantic Capital Investments, LLC (ACI), a 'fee-only' Registered Investment Advisory firm located in Mount Pleasant, SC.

The Wisdom of Asset Allocation

"God grant me the serenity to accept the things I cannot change, courage to change the things I can, and the wisdom to know the difference."  Reinhold Niebuhr (1892-1971)

Those words underscore the foundation of prudent investing.  There are things we can control and there are things we can not. Knowing the difference is imperative and "the wisdom" lies in the application of that knowledge... 

Among the primary variables of investing, the investor may control: (1) the amount to be invested; (2) the allocation of the assets; (3) the holding period or time in the market; and (4) the timing of the investment.  Where investors make their biggest mistake is focusing intently on trying to control the one investment variable that is uncontrollable -- (5) the outcome of the investment (amount of gain/loss)... 

Although most investors understand that the vast majority do not beat the market averages, especially over long periods of time, it is in our fallible human nature to believe that we will be among the "above average."  Whether one ascribes to Jack Bogle's rantings on Lake Wobegone, where everyone is above average, or to the validity of the Efficient Market Hypothesis (EMH) or not, it is difficult to argue against the evidence that the greatest advantages to be gained by the investor is within a combination of the four investment variables that are controllable.

The Amount to Be Invested:

Alone, this variable is the weakest so I won't place much energy here; however it should go without saying that investing more money (all other variables remaining constant) will yield the investor more at the end of the investment horizon than keeping the investment amount constant.  It's simple math. 

Asset Allocation:

Location, location, location.  As with real estate, the location of an asset is a critical element to its success.  The most commonly understood (and misunderstood) piece of asset allocation is with securities selection.  Since I've put forth significant energy to this area in previous posts, feel free to brush up on your asset allocation skills with a review:

• For an introduction to asset allocaton, check here.
• For the most efficient form of asset allocation, check here.
• For a pure balanced approach, check here.
• If you are interested in active management check here and here.

For purposes of this post, I'll expand on an often over-looked yet integral piece of the asset allocation puzzle -- tax efficiency:

• Tax-inefficient assets, such as actively-managed and traded investments that are subject to short-term capital gains, are best held in tax-deferred accounts, such as IRAs and 401(k)s.
• Other tax-inefficient assets are those that generate taxable income such as REITs and corporate bonds.  These also are best held in tax-deferred accounts.
• Conversely, tax-efficient ETFs and index funds are best held in tax-inefficient or "taxable" accounts such as a brokerage or joint accounts.
• Some would argue that placing growth stocks in tax-advantaged accounts is prudent; however, if done correctly, placing those stocks or funds in taxable accounts can be beneficial (if the growth stocks appreciate, the investor harvests the returns at the lower capital gains rate and when there are losses, the losses can be "harvested" as tax deductions, where those losses are not deductible in a tax-advantaged accounts).
• While each case is different, in general, a Roth IRA is favorable to the traditional IRA as the investment horizon increases.

Time In The Market:

I believe time in the market, with proper asset allocation, is preferable to "timing the market," which is a fool's game.   In my view, time in the market refers to investing early, investing often, and staying in for the long-term.  Albert Einstein called compounding interest "the most powerful force in the universe" and it represents "time in the market" at its best.  Here's a classic example:  Which would you rather have -- $1million today or one penny doubled every day for one month?  If you chose the penny doubled then you are the "winner" with $5,368,709.12.  Time exponentially expands the compounding effect.  With less time to invest, even the most skilled traders will find themselves at an enormous disadvantage to compounding interest...

Timing the Market / Investment Outcome:

Since "timing the market" is intended to control the "investment outcome," I combine them into the same points:  As for timing the market, of course it is a "controllable" investing variable and it is possible to accomplish successfully but how prudent can it be to attempt when the vast majority of investors are not successful at doing it? 

Where investors are commonly misled here is with their own perception of investment gains and "chasing performance."  For example, if you invest $100,000 into a stock and it returns 30% in the first year and loses 10% in the second, is your average return 20 percent? No.  After the first year, you'll have $130,000 and after the second, you'll have $117,000 for a total gain of 17% (or roughly 8.5% compounded).  If you just earned an "average" 10% per year, you'd have $121,000 at the end of year two.  Now consider that you were the "average" investor and your "friend" earned 30% in the first year.  Are you going to hold to your allocation earning "just" 10% or will you be tempted to jump to your friend's "strategy?"  Being "average" has its merits...

While anyone can throw darts at a wall and beat the markets over a short period of time, the markets are too efficient to outperform consistently over longer periods time.  Investors should not use stocks as short-term investment vehicles, anyway, and any person calling themselves a "financial philosopher" would not partake in such pursuits.   

In summary, investing should be a means of making money work for you not a means of making you work for it.  As author, Mitch Anthony, puts it, "life is not about making money, money is about making a life."

Now get on with your life...

You may see this blog post and others like it at the Carnival of Financial Planning.

TFPAuthor, Kent Thune, is the President and Owner of Atlantic Capital Investments, LLC (ACI), a fee-only, registered investment adviser based in Mount Pleasant, SC, near Charleston.  ACI specializes in retirement, investments, and financial planning.