Yahoo Finance How to Use Asset Allocation Tools to Guide Your Investments
Any investing expert will tell you that the most important factor in building your portfolio is how you divide your money between stocks, bonds and cash. But applying that knowledge is no easy task, especially for the do-it-yourselfer.
"It's going to be really difficult for the individual investor with no help to come up with an asset allocation that's going to beat a good financial advisor in terms of diversification," says Ryan McGuinness, president of CTR Financial in Lincolnshire, Illinois.
"The reason is that rules of thumb don't really give you room for more complexity," he adds, referring to the need for a wide variety of stocks and bonds, and adjustments for changing circumstances.
To set up an asset allocation strategy, the investor must hack through a jungle of advice, theories, questionnaires and, these days, perhaps turn to an online calculator. So how do you choose one and then avoid the pitfalls?
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"All online tools only work if you give them the right information," McGuinness says.
Asset allocation generally relies on past patterns, such as the tendency of stocks to beat bonds and cash over long periods, and the fact that bonds and cash, while less generous than stocks, are not as risky. The general practice is to emphasize stocks for young investors, who have time to ride out downturns and benefit from those bigger returns. Investors in or near retirement are more likely to emphasize bonds and cash, choosing safety over big gains. Middle-aged investors are told to have a mix somewhere in the middle.
A traditional rule of thumb is to subtract one's age from 100 to get the ideal percentage of stock allocation in a portfolio -- a 40-year old would have 60 percent in stocks, for instance. The balance would go to safer assets
But things have changed.
"That rule of thumb has been around for quite some time and hasn't been updated to reflect the new realities that people are living longer and need to fund a longer retirement period," says Bob Johnson, president of The American College of Financial Services in Bryn Mawr, Pennsylvania.
A 75-year old trying to make his money last 25 more years really needs to have stocks to keep up with inflation -- perhaps 50 percent of the portfolio, not 25 percent. But it's not that simple: If he can count on a healthy pension and sizable Social Security benefit, he can afford a riskier portfolio than an investor without this safety net. On the other hand, he may not need to reach for big returns but would prefer to simply safeguard what he has. Dilemmas like that make do-it-yourself asset allocation tricky.
Today, investors can choose from an array of allocation tools, online or run by their financial advisors.
Simple retirement calculators. These use inputs for the user's current assets and annual savings, as well as assumptions on average annual investment return, inflation and life expectancy. The calculator figures how big your nest egg could grow and how much annual income it would produce and for how long. The best of these calculators provide allocation recommendations and tips to guide your input for returns, inflation and life expectancy.
The problem with these, as well as many more elaborate tools, is what computer folks call "garbage in, garbage out" -- inputs for returns and inflation rates may be too rosy or gloomy, making the results useless.
"These simple tools also fail to take into account changes in life circumstances. For instance, if a spouse stops working or an additional child is born," Johnson says.
To get the most out of this kind of calculator, you can do multiple runs using different assumptions, to assess the best and worst case.
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Interactive tools. This category includes a range of tools that figure a likely investment return after selecting an asset allocation based on the user's answers to questions about age, assets, needs in retirement and so forth. In addition to crunching numbers, these tools use questionnaires on factors like the user's risk tolerance. What, for example, would you do if your portfolio lost 10 or 20 percent -- sell everything, stand pat or buy more? One who answers "sell" would be deemed less tolerant of risk than one who says "buy," and would be steered toward a safer allocation light on stocks and heavy on bonds.
Again, the problem is the tool may simply adopt the user's misconceptions, proposing a safe portfolio for the "risk averse" that might provide inadequate returns, while a professional financial advisor would tell you that you'd have plenty of time to recover from a bear market and not to worry.
Indeed, many investors misjudge their stomach for downturns, says Dennis P. Ryan, financial advisor at World Equity Group in Arlington Heights, Illinois.
"I have clients who stated that they are fairly aggressive investors when I first met them and then they call me in a panic when their portfolio is down 1 percent for the year," he says. "Perhaps the greatest value that human advisors play is talking people off the ledge when markets become volatile."
Monte Carlo simulators. These are the Cadillac tools, generally offered by financial services firms, though some are available for free online. The user answers a number of questions and then the computer, rather than assuming the same inputs for each year, does thousands of runs, each with different assumptions. In effect, it asks, "What if you earn 2 percent in year one, lose 5 percent in year two, make 10 percent in year three and so on?" The program then reports the percentage of runs that produced enough retirement income for long enough. You can play with different asset allocations to see which mixes have the best odds of success.
"We are confident in working with a client who has an 80 percent chance of a successful retirement," says Ryan Kwiatkowski, director of marketing at Retirement Solutions in Naperville, Illinois. "If a client or prospect is below 80 percent, we'll find a way to get there by a reduction in (retirement spending), or by extending a career."
While some sophisticated asset allocation tools are offered for free online, McGuinness favors the asset-allocation feature from Betterment, a robo-advisor that charges 0.15 percent of the account value for portfolios of $100,000 or more.
No matter how exotic the progam, the user has a key role that requires discipline and sticking with the plan, says Nick Bradfield, founder of Divvy Investments in Cary, North Carolina.
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"The key with using the tools is to make very conservative assumptions," he says. "It will force you to come up with ways to save more, instead of investing more aggressively than you can stomach."
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