Last week's blog, I spoke about why most investors should use index mutual funds or indexed ETF (exchange-traded funds) as their investment vehicle. This week's article discusses how much you put in equity(stocks) funds and bond funds. Most advisors usually ask their clients to complete a risk tolerance questionnaire. I find using risk questionnaires are not very useful in uncovering a client's risk tolerance. They often too long and cumbersome and a waste of my client's time. I use the following process to discover my clients' risk tolerance:
Please keep it simple to implement your investment allocation. My first question to you is, "what is the most significant annual investment loss you are willing to tolerate to get the best returns?
I can tolerate losing _________% Percent of % stocks invest
You can fine-tune your allocation by determining how many years until you want to spend your money. For example, my time horizon for spending my retirement is ten-years. As a rule, I use a factor of 5 times the years I want to access these funds. In my case, five times 10 equals 50. I should not exceed 50% allocation to stocks. I fine-tune my share a little higher than 60% because I can tolerate a loss of at least 25%.
Once you establish your stock allocation, you then need to decide which asset classes you want investing. Asset class selection is determined by how much complexity you can tolerate. For example, I invest in four asset classes:
U.S. large stocks (Vanguard Dividend Appreciation Index Fund)
U.S. small stocks (Vanguard Small-Cap Index Fund)
Foreign Large stocks (Vanguard International Dividend Index Fund)
U.S. short-term bonds (Vanguard Short-Term Government Index Fund)
Determining asset class allocation can be as complicated or simple as you want. I try to keep my asset class picks very simple. As I mentioned in my previous blog, I use Vanguard and Dimensional Funds as my two leading index fund families. If you need help in determining your allocation and asset class selection, please contact me at firstname.lastname@example.org. It is free. No strings attached. It does not matter if it is your 401k account, IRA, or your private investment account.
Stock Market Outlook-Robin Who?
Recently, the news has been reporting about the rise of the Game Stop stock popularized by Reddit social media posts about how small investors can back at the Wall Street establishment. Many small investors are buying the Game Stop stock through the trading platform Robinhood. Retail investors are using technology and social media to equalizing the investment playing field. Don't get me wrong, and if it were not for technology and social media, it would make it tough to handle the number of clients I have in my business.
Trading is a dangerous game to play. Reddit and Robinhood have encouraged many inexperienced people to play in the stock market with money they cannot afford to lose money. Michael Hiltzik business writes in the Los Angeles Times on Tuesday, February 2nd, "What's amusing, in a sad way, is the notion among small investors that they're striking a revolutionary blow against the Wall Street establishment." Mr. Hiltzik, in his article, interviews unemployed Angeleno, who invested more than he received from the government coronavirus stimulus check in GameStop as his goal is to bankrupt these billionaires. Trading stocks is a game that requires knowledge, experience, money, and luck, which is in short supply in the small investor community. What small investors are doing is the castle in the sky trading, not investing. There is a saying in the investment business, "When small investors enter the market, it is time to leave the party." When they go out to a party, I tell my kids, "nothing good happens after midnight." The clock is nearing midnight. As in Cinderella, when the clock hits midnight, it's only mice, pumpkins, and more impoverished stock traders. A trading activity like GameStop is another example of the high-level risk is increasing the chances of a severe market downturn is a high probability.
Next week's blog will update the market valuation and the most significant risk we all have to determine in our life.