Expected Return: Avoid The Seduction of Big Numbers

When it comes to expected return, we love big numbers. We gravitate to it like paparazzi to a celebrity. We do it with performance and projections because it sells.

But there’s one tiny problem. Our expectations change with the market.

A while back I covered how asset allocation lowers volatility. In it, I showed how four different asset mixes performed against an all stock and an all bond portfolio. It looked like the graph below. It showed how volatility lowers as you decrease the amount of stocks in your portfolio. But did it?

Of course it did. It was a simple exercise to prove a point. But it also showed how much better an all stock portfolio performed over the same period. Continue Reading…

How A Simple Allocation Reduces Portfolio Volatility

Simple Portfolio AllocationLast week I dug into alternatives to low volatility ETFs. In it, I hinted at a another, simpler way to reduce portfolio volatility. It starts with diversification. But it ends with the asset allocation you choose. In other words, you can build a simple portfolio of stock and bond funds that limit the impact of market volatility. In most cases simpler is better. That is the goal here, to show how the simplest allocation strategy can reduce volatility in your portfolio.

Market Volatility

To understand market volatility we need to understand what moves the markets: why stock prices move and the same for bond prices. Most of the causes can be reduced to rumors, news, political, economic, and disasters. Let’s not forget our own behavior plays a role too. Continue Reading…

The Importance of Diversification

DiversificationIf you’ve ever heard “don’t put all your eggs in one basket”, it’s used to describe a simple investing principle known as diversification.

What Is Diversification?

Diversification is a way to lower risk by allocating your portfolio across various investments and asset classes. In doing so, it should limit your losses and lower volatility while still providing the best possible return for your money.

Diversification is the heart of many asset allocation models. When used correctly, it will help you reach your financial goals without taking on undo risk.

Why You Diversify

The purpose of all this is to reduce investment risk and prevent losses. You do this by dividing your portfolio among different assets classes – stocks, bonds, real estate, cash, and other investments. Continue Reading…

Bond Basics: Bond Price And Yield Relationship

Bond Price and YieldOne of the more confusing aspects of bond investing is the relationship of bond price and yield.  As bond investors we want high prices and high yields but it’s just not possible.  At least not at the same time.  This is where the confusion begins.  In a time where interest rates are at all time lows, understanding the bond price and yield relationship is important.

Bonds play an important part of every portfolio.  The basic asset allocation strategy says to have your age as the percent of bonds in your portfolio.  I could argue for more or less based on interest rate risk and current yields, but that’s a post for another day.  The bottom line is we should have some bond exposure in our portfolio.  For now, lets just stick to the basics of the bond price and yield relationship.

Bond Yield

New bonds are issued at face value (par), with a time to maturity, and a yield (coupon rate) that involves several factors including risk.  Bond yield is the return you will receive if you hold the bond till maturity.  It’s in annual percentage form.  So a bond with a 5% yield, will pay a 5% return each year until the bond matures. Continue Reading…

Asset Allocation And The Benefits Of Rebalancing

The beginning of a new year is a time for review, reflection and resolutions.  When it comes to your money it’s the perfect time to set goals, make changes and resolve to stick to those changes long term.  Whether it’s setting up and funding an IRA or just putting extra money aside for a rainy day, whatever the goal, how your money is invested, its asset allocation, and consistent rebalancing will be some of the most important decisions you’ll make as an investor.

What Is Asset Allocation?

Asset allocation is an investment strategy based on finding a balance for your money between different assets that fits your goals and risk level.  These assets are broken down into three main classes – equities (stocks), fixed income (bonds) and cash – which will make up your investment portfolio.

Unfortunately, there is no simple formula for figuring out your perfect asset allocation.  But there are some rules of thumb to follow.  The most important decision will be the split between risky and non-risky assets or your stock/bond split.  A conservative rule is to have “your age in bonds”.  According to this rule, if you are 40 years old, 40% of your portfolio would be in bonds.  For those who prefer more risk (age – 10) adjustments can be made.  It offers a starting point.  Once you have an asset allocation that you’re comfortable with, it’s time to make sure you stick to it.

The Importance of Rebalancing

Continue Reading…