Financial literacy covers a wide range of topics, from saving and insurance, to budgeting and borrowing, to financial investing. The purpose of this article is to foster financial literacy by explaining the foundation for the establishment and implementation of a target asset allocation. My intent is to provide an example of applied financial theory, rather than a purely conceptual analysis. In future articles, I will illustrate the implementation of the asset allocation, and I will discuss and apply techniques to modify the investment portfolio in ways that may provide returns (and risk) over and above the market indexes. This incremental return is commonly called "alpha" and it seemed like an appropriate topic for the site. I'm not going to give stock picks or anything like that, but future articles will present some potential mutual funds and ETFs which can be used to implement the target investment strategies which are presented.
First, the reader needs to identify the type of investing that most clearly matches his or her risk profile. There are many flavors of these evaluations, and what follows is my personal approach to helping people understand why they are investing. So, get out a paper and start jotting down your responses to the following questions.
Risk Profile Questions
- Besides retirement, do you have any specific goals? How much? When? (Wedding, Car, House)
- Do you have six month's living expenses set aside in a money-market account?
- Do you have a life insurance policy?
- Have you ever written a budget? Do you track it?
How important is money to you?
- Do you care if your investments vary significantly up and down during your investment time horizon?
- What did you do when the markets were down big in 2008?
- If you were trading in 2000, what did you do when the dot.com bubble popped?
- If you were trading in 1987, what did you do in October?
- If you lost 50% of your investment account, would you be depressed?
- Have you ever been "tested" in real life with large financial losses?
- Did you inherit money?
Why are you investing?
- Are you investing to save for retirement?
- When will you retire?
- Do you know how much will you need?
- Are you trying to amass a specific amount for a special reason?
- Are you trying to earn a specific monthly income?
- Do you have a time period in mind where you will liquidate this account?
- Have you ever bought individual bonds?
- Have you ever bought individual stocks?
- Have you ever shorted a stock?
- Have you ever traded on margin?
- Do you feel stupid when you lose money in the stock market?
- Do you feel smart when you make money in the stock market?
- Do you measure your performance against the S&P or some other benchmark?
- Do you set, and enforce stop limits on trading positions?
- Have you experienced a life event which may alter your risk appetite? (Marriage / Divorce? New Children? Retirement?)
- Do you have a spouse/partner?
- Do you share investment decisions?
- Have you ever worked with a financial advisor?
You can reflect on your answers as we go through the next section, but some of the above questions merit immediate discussion.
- If you don't have an emergency fund set up, then your primary investment activity should be to begin saving and placing those funds into a money market account. We can get back to stocks and bonds once you've established the basics.
- If you don't share investment decisions with your life partner, you should at least discuss the activities once or twice a year.
- If your emotions are swayed up or down by investing, you might want to invest conservatively or outsource the process to a financial advisor.
- If you're working with a financial advisor and have not had some similar discussion along the lines of the above questions, then you need to find a new advisor!
Determine Investment Pattern based on Risk Profile
Once you have had time to contemplate the above questions, try to fit your situation into one of the following categories of investor: conservative, aggressive, goal-oriented, income.
You are probably a Conservative Investor if:
- You are retiring within 5 years, and you don't have a surplus of wealth
- Your stomach hurts if you lose money in the stock market
- You need the money for a specific purpose or goal, and failure to meet your goal would damage your lifestyle or self-esteem
- You have never shorted a stock or traded on margin
You are probably an Aggressive Investor if:
- You have many years ( >15) until retirement
- You have an emergency fund, life insurance, extra savings for specific goals and/or a moderate- or well-funded retirement/pension
- You are investing inherited money that you don't need for daily survival
- You have dabbled at various trading activities, shorting stocks, day-trading, buying on margin, etc.
- You have lost money and made money in the stock market
- Your monthly income goals are fully met from sources other than your active financial investments (annuity, pension)
You are a Goal-Oriented Investor if you are saving for a well-defined purpose, e.g.,
- want to retire in 10 years, and will need $2 million as a nest egg at that point
- need to amass $300 K for children's college expenses in 12 years
- want to put aside $100K for a house down payment in 5 years
You are an Income Investor if:
- You are retired, and you are investing to get a certain monthly payout
- You use your investment account returns like a paycheck, and they support your lifestyle
- You inherited a lump sum, and you use this to supplement your income so you can pursue a career that offers a modest salary but large emotional rewards.
The above are examples from people that I have met, invested with, and advised. The list is illustrative, but not exhaustive and you can use them as hints to see where you would classify your own risk profile. If you're stuck, it's time to call a financial advisor. If not, then let's keep going…(future articles will hopefully appear on Seeking Alpha)