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Steve's note: This weekend's piece is a little unusual for us. Rather than our typical essay format, we're featuring an interview from our sister site, The Daily Crux, with my friend and colleague Dr. David Eifrig.
"Doc," as we call him, is a former professional trader for Goldman Sachs. He now advises tens of thousands of people on how to manage their retirement portfolios. And the idea he covers below is likely the most important factor in your long-term success as an investor...
This Idea Is 100 Times More Important Than Any Stock PickBy
Saturday, December 17, 2011
The Daily Crux: Doc... many investors spend a lot of time and energy trying to pick the right stocks. But one's success as a stock picker actually plays a relatively small role when it comes to increasing wealth through investing... much smaller than the average investor realizes.
A much more important aspect to successful investing is called asset allocation. Can you explain what this is and why it's so important?
Dr. David Eifrig: I'd be happy to. Asset allocation is how you balance your wealth among stocks, bonds, cash, real estate, commodities, and precious metals in your portfolio. This mix is the most important factor in your retirement investing success.
It's 100 times more important than any stock pick. It's 100 times more important than knowing the next hot country to invest in... or what option to buy... or knowing what the housing market is doing... or whether the economy is booming or busting.
I've seen ignorance of this topic ruin more retirements than any other financial factor.
Crux: How can it ruin a retirement?
Doc: Many people have no idea what sensible asset allocation is... So they end up taking huge risks by sticking big chunks of their portfolios into just one or two investments.
For example, I have a friend who had most of her wealth in real estate investments in 2006. When the market busted, she lost a huge portion of her retirement funds.
Or consider employees of big companies that put a huge portion of their retirement money into company stock. Employees of big companies that went bankrupt – like Enron, WorldCom, Bear Stearns, and Lehman Brothers – were totally wiped out. They believed in the companies they worked for, so they put more than half of their retirement portfolios into company stock.
And it's all because they didn't know about proper asset allocation. Because of this ignorance, they lost everything.
I'm sure you can see from these examples that asset allocation is so important because keeping your wealth stored in a good, diversified mix of assets is the key to avoiding catastrophic losses.
If you keep too much wealth – like 80% of it – in a handful of stocks and the stock market goes south, you'll suffer badly. The same goes for any asset... gold, oil, bonds, real estate, or blue-chip stocks. Concentrating your retirement nest egg in just a few different asset classes is way too risky for you. Betting on just one horse is a fool's game.
Crux: This seems like simple common sense... to spread your risk around.
Doc: I agree. But not doing it is an extremely common mistake people make.
Crux: Could you walk us through what asset classes are out there... and what a sensible mix looks like?
Doc: First off, you have one of my favorite assets in the world, which is cash.
"Cash" simply means all the money you have in savings, checking accounts, certificates of deposit (CDs), and U.S. Treasury bills. Anything with less than one year to maturity should be considered cash.
I like to keep plenty of cash on hand so I can be ready to buy bargains in case of a market collapse. Investors flush with cash are often able to get assets on the cheap after a collapse – they can swoop in and pick things up with cash quickly, and often at great prices.
I generally recommend holding between 10% and 45% of your assets in cash, depending on your circumstances. In fact, one of the major tenets of good financial planning is to always have at least 12 months of living expenses in cash in case of disaster. If you haven't started saving yet, this is the No. 1 thing to do today.
Next, you have conventional stocks. These are investments in individual businesses or investments in broad baskets of stocks, like mutual funds and exchange-traded funds (ETFs). Stocks are a proven long-term builder of wealth, so I think almost everyone should own some. But keep in mind... stocks are typically more volatile than most other assets.
Just like you should stay diversified overall with your assets, I think you should stay diversified in your stock portfolio. I once heard a well-known TV money show host ask callers: "Are you diversified?" According to him, owning five stocks in different sectors makes you diversified. This is simply not true. It is a dangerous notion.
The famous economist Harry Markowitz modeled math, physics, and stock-picking to win a Nobel Prize for the work on diversification. The science showed you need around 12-18 stocks to be fully diversified.
Holding and following that many stocks might seem daunting – it's really not. The problem is easily solved with a mutual fund that holds dozens of stocks, which of course makes you officially diversified.
Crux: Let's discuss a few more asset categories.
Doc: Next, you have fixed income securities, with are generally called "notes" or "bonds." These are basically any instrument that pays out a regular stream of income over a fixed period of time. At the end, you also get your initial investment – which is called your "principal" – back.
Depending on your age and tolerance for risk, bonds sit somewhere between boring and a godsend. The promise of interest payments and an almost certain return of capital at a certain fixed rate for a long period of time always lets me sleep well at night.
Adding safe fixed-income bonds to your portfolio is a simple way to stabilize your investment returns over time. For people with enough capital, locking up extra money (more than 12 months of your expenses) in bonds is a simple way to generate more income than a savings account.
Another asset class is real estate. Everyone knows what this is, so we don't need to spend much time covering this. If you can keep a portion of wealth in a paid-for home, and possibly some income-producing real estate, like a rental property or a farm, it's a great diversifier.
Crux: Do you consider precious metals, like gold and silver, an important piece of a sensible asset allocation?
Doc: I do... But gold and silver, to me, are like insurance.
Precious metals like gold and silver typically soar during times of economic turmoil, so I want to own some "just in case."
But I'm different than the standard owner of gold and silver, who almost always believes the world is headed to hell in a hand basket. I'm a major optimist, but I'm also a realist. I believe in owning insurance. I believe in staying "hedged."
For many years, my job at Wall Street bank Goldman Sachs was to develop and implement advanced hedging strategies for wealthy clients and corporations. The goal with these strategies was to protect jobs, wealth, and profits from unforeseen events.
During those years, I learned a big difference between wealthy people and poor people. Wealthy people almost always own plenty of hedges and insurance. They consider what could happen in worst-case scenarios and take steps to protect themselves. Poor people tend to live with "blinders" on.
So just like I wear my seat belt while driving, I own silver and gold – just in case. For most people, most of the time, keeping around 5% of your wealth in gold and silver provides that insurance.
Crux: That's a great view of gold and silver. So... you've covered five broad categories... cash, stocks, bonds, real estate, and precious metals. Do you have any guidelines on how much of each asset folks should own?
Doc: There's no way anyone can provide a "one size fits all" allocation. Everyone's financial situation is different. Asset allocation advice that will work for one person can be worthless for another.
But most of us have the same basic goals: Wealth preservation... picking up safe income... and safely growing our nest egg. We can all use some guidelines to help make the right individual choices. Keep in mind, what I'm about to say are just guidelines...
If you're having a hard time finding great bargains in stocks and bonds, I think an allocation of 25%... even 50% in cash is a good idea.
This sounds crazy to some people, but if you can't find great investment bargains, there's nothing wrong with sitting in cash, earning a little interest, and being patient. If great bargains present themselves, like they did in early 2009, you can lower your cash balance and plow it into stocks and bonds.
As for stocks, if you're younger and more comfortable with the volatility involved in stocks, you can keep a stock exposure to somewhere around 33%-50% of your portfolio. A young person who can place a sizable chunk of money into a group of high-quality, dividend-paying stocks and hold them for decades will grow very wealthy.
If you're older and can't stand risk or volatility, consider keeping a huge chunk of your wealth in cash and bonds... like a 75%-85% weighting. Near the end of your career as an investor, you're more concerned with preserving wealth than growing it, so you want to be very conservative.
Crux: Great advice. Any last thoughts?
Doc: As you can see from my guidelines, the big thing to keep in mind with asset allocation is that you've got to find a mix that is right for you... that suits your risk tolerance... your station in life. Whatever mix you choose, just make sure you're not overexposed to an unforeseen crash in one particular asset. This will ensure a long and profitable investment career.
Crux: Thanks Doc.
Doc: You're welcome.
Further Reading:
Doc says if you can master this technique, you can avoid a huge amount of worry and wasted time and set yourself up to make extraordinary returns...
If you're ready to start safely doubling or tripling the trading gains you normally make in your retirement account – with much less risk – Doc says you need to think like a long-term investor... and stick with these three simple rules.
If you're looking for a conservative, high-income, retirement-friendly trading strategy, you can't find a better tool than this one…
Market NotesCHART OF THE WEEK: THE YEAR OF THE RESOURCE WIPEOUT Our chart of the week shows why many folks will remember 2011 as "the year of another resource stock wipeout."
Regular DailyWealth readers know the resource sector – the business of exploring for and extracting natural resources, like oil, gold, copper, and uranium – is one of the market's greatest "boom and bust" sectors. It goes through huge uptrends and equally huge downtrends. One of the keys to making money in this sector is to avoid the huge busts... like the one that occurred in 2011.
Back in May, we noted the soggy price action in Brazil's benchmark stock index and warned readers to get cautious toward commodities and resource stocks. Below is a three-year chart of the TSX Venture Index, which shows this caution was warranted.
The TSX Venture Index is one of the most widely followed gauges of resource stock price action. As you can see, the "Venture" boomed in 2010 and early 2011. It ran from 1,400 to 2,400 (a 70% gain) in eight months. But as folks grew weary of riskier assets, they dumped resource shares. They dumped enough of them to make 2011 a "round trip" year back down to the 1,400 level. We have no doubt this bust will be followed by another boom. It's just a matter of time.
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Stat of the week
7,000
Number of McDonald's restaurants in Europe. According to the Associated Press, Europe is the company's largest market.
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