The Financial Survival Guide to Retirement

Investment Theory

Review

• Asset allocation is the single biggest determinate of portfolio results

• Major asset classes– Stocks– Bonds,– Cash

• How you allocate your investments depends upon the returns you need and risk you can take

• Rule-of-thumb: %stock = 100 - age

Where We Stand

• You have determined your:1. Investment objective 2. Risk tolerance3. Asset allocation

• Now - what investments do you buy in each asset class?

Financial Planner Exercise

• Who is the best financial planner in class?

Modern Portfolio Theory

• Asset class investments tend to move together – correlation– For example, in a recession

• But investments do not always move together– For example, high oil prices are good for oil

companies but bad for airlines– Bad quality may affect only one company

• Diversifying your investments, can increase your average return and lower your risk!

Not All Risk is the Same

Firm Risk = Systemic risk + Idiosyncratic Risk

BusinessCycles

FinancialMarkets

GlobalConditions

Risk Unique to theFirm

Source of Correlation

Idiosyncratic risk can be diversified away!

Diversification – Simple Example

IBM and AT&T

When IBM went down, AT&T went up.When AT&T went down, IBM went up.Not always. Maybe we should add moreor different stocks.

With large portfolio, 30 – 200 stocks, idiosyncratic moves cancel out!

Adding Investments Can Reduce Risk

Risk and Diversification

Note: adding some stock to a 100% Treasury portfolio increases the return and decreases the risk!

Modern Portfolio Theory

• Optimal portfolios are a combination of the risk free asset and a market portfolio.

• Implications– Buy a money market fund (~risk free)– Buy an index fund (the market)– Asset allocation is determined by your risk

tolerance

• Big Question – what is the market?

Modern Portfolio Theory

Foreign Diversification

Efficient Markets Hypothesis

• Markets prices reflect all known information• You can not beat the market consistently without luck

– Advisors may be correct, just not consistently– Advisors love to talk about winners but not losers– Survivorship bias

• What to do?– Go with the market– Invest in broad market index funds– Less than 3% of actively managed funds beat index funds over

last 20 years*

* “Index Funds Win Again,” NY Times, Feb. 22, 2009.

Index Funds

• A fund is a pool of securities that allow investors to buy a share of many securities

• Many index funds available for stocks and bonds

Vanguard Index 500Total Stock Market

Index Total Int’l Stock IndexTotal World Stock

IndexLong Term Bond

Index

Fidelity500 IndexTotal Market IndexInternational IndexU.S. Bond Index

SchwabS&P 500 IndexTotal Stock Market

Index International Index

Target Date Funds

• “Index” Funds whose asset allocation becomes more conservative over time

• Percent of stocks goes down, bonds go up• Issue

– What happens after target date?– You still have many years to go– Retirees face inflation risk, do not want to be too

conservative– What does fund do after target date?

Building Your Market Portfolio

Scott Burns' Lazy Portfolios

Coach Potato Portfolio:- 50% in Vanguard Total Stock Market Index Fund (VTSMX)- 50% in Vanguard Inflation Protected Securities Fund (VIPSX)

Margarita Portfolio:- 33.3% in Vanguard Total Stock Market Index Fund (VTSMX)- 33.3% in Vanguard Inflation Protected Securities Fund (VIPSX)- 33.3% in Vanguard Total International Stock Index Fund (VGTSX)

Four Square Portfolio:- 25% in Vanguard Total Stock Market Index Fund (VTSMX)- 25% in Vanguard Inflation Protected Securities Fund (VIPSX)- 25% in Vanguard Total International Stock Index Fund (VGTSX)- 25% in Vanguard REIT Index (VGSIX)

Building Your Market Portfolio

Five Fold Portfolio:- 20% in Vanguard Total Stock Market Index Fund (VTSMX)- 20% in Vanguard Inflation Protected Securities Fund (VIPSX)- 20% in Vanguard Total International Stock Index Fund (VGTSX)- 20% in Vanguard REIT Index (VGSIX)- 20% in American Century International Bond Fund (BEGBX)

Six Ways From Sunday Portfolio:- 16.65% in Vanguard Total Stock Market Index Fund (VTSMX)- 16.65% in Vanguard Inflation Protected Securities Fund (VIPSX)- 16.65% in Vanguard Total International Stock Index Fund (VGTSX)- 16.65% in Vanguard REIT Index (VGSIX)- 16.65% in American Century International Bond Fund (BEGBX)- 16.65% in Vanguard Energy (VGENX)

But You Want More

• Not happy with getting what everyone else gets?• More potential return means more real risk• NOT ALL RISK IS REWARDED

– Think you can beat the pros?– Some will win, others will lose– Beware greed (remember Madoff?)

• Take risk knowingly, intelligently

Post Modern Portfolio Theory

• Any investment other than the market is a bet• Bets are zero-sum propositions• Can you beat the pros?

Post-Modern Portfolio Theory

• Divide your portfolio into two parts• Alpha

– Percentage of your portfolio that you are willing to “bet”

– Can be individual stocks or bonds, or funds• Beta

– Percentage of your portfolio to invest in the market

– Invest according to your asset allocation– Use index funds for asset classes

Example

• Your investment objective– You want to save for retirement

• Your risk tolerance– You can take some risk but want to be able to

sleep at night

• Your alpha– You believe Asian stocks will beat the market– Willing to bet 10% of your money

Example – Your Investments

• Alpha– Buy Asian index fund with 10% of your money

• Beta– Asset allocation with moderate risk– 60% stocks

• Purchase a total stock market index fund– 35% bonds

• Purchase total bond market index fund– 5% cash

• Purchase a money market fund

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Twelve Financial TruthsJonathon Clements, WSJ 6/18/06

1. It’s hard to cut back2. You will never be satisfied3. Borrowings have to be repaid4. Fancy cars and expensive clothes are not a

sign of wealth5. Your family could prove to be your

greatest liability6. Investors face three enemies

1. Inflation2. Taxes3. Investment costs

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Twelve Financial TruthsJonathon Clements, WSJ 6/18/06

7. Adding investments can lower risk8. Diversification is a mixed bag9. Not all risk is rewarded10.Most investors fail to beat the market11.Change is costly12.Your best investment strategy is saving

Summary

1. Determine your investment objective2. Know your risk tolerance3. Identify your alpha and beta

• Alpha – percent you are willing to bet• Beta – percent invested in the market

4. Place your bets with your Alpha5. Invest Beta according to asset allocation

• Use index funds to match the market

Homework

• What investment theory do you believe?• How will that guide your investing?• Do you have an investment strategy?