How To Manage Personal Finances Book: Chapter 17: Roller Coaster Fears and Asset Allocation Models
Author’s Note:
I am posting a text version of this entire book on Substack, and video versions on YouTube. Email ken@stltest.net for details on my 5th book’s publishing date in late ’24 or early ’25.
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I don’t like roller coasters.
In fact, I don’t care for any type of amusement ride.
About 10 years ago, we took our kids to our community’s annual carnival, and I rode The Scrambler. Dad had to go home because he was dizzy…
In the same way, no one likes sharp declines in the stock market from year to year. In Chapter 11, I used Seeking Alpha’s data on the history of the stock market.
“Over 88 years, the S&P 500 went up 64 years and went down 24 years…. The worst return was -43.84% in 1931. The best return was 52.56% in 1954.”
Now, THAT’S a roller coaster.
But don’t panic.
Consider the long-term performance of the Standard and Poor’s (S&P 500) index of stocks.
Investopedia explains that “The average annualized return since its (S&P 500’s) inception in 1928 through Dec. 31, 2023, is 9.90%. The average annualized return since adopting 500 stocks into the index in 1957 through Dec. 31, 2023, is 10.26%.”
Investors should focus on that long-term average.
Edward Jones has told investors for years that: “Time in the market is more important than timing the market.”
Over time, the market has recovered. That has to be true, or the average return over time would be negative- not positive.
How to measure stock volatility
Beta is a term that measures volatility in the price of an investment, and beta is a useful tool for investors to understand risk.
Assume, for example, that you’re buying stock in IBM, a large company. Analysts will measure the volatility of IBM’s common stock by comparing the stock price change to the performance of an index. If the S&P 500 is used, this index is referred to as the benchmark for the beta calculation.
Here’s how beta works:
A beta of 1 means that IBM stock moves up and down in perfect correlation with the index. If the S&P 500 index goes up 7%, so does the IBM stock.
Betas of less than 1 mean that the stock is less volatile than the index.
A beta of more than 1 indicates that the stock is more volatile.
If you prefer less fluctuation, choose a low-beta stock. Investors who want to take more risk look for high-beta stocks.
Why not group investments by type, rather than evaluate one investment at a time,?
A Better Way: Asset Allocation Models
Nearly every financial advisory firm offers a model investment portfolio. It’s an ideal blend of stock, bonds, and other investments, based on your age, risk tolerance, and investment goals. For this discussion, I’ll focus on only stocks and bonds.
This great Forbes article provides three models:
Income portfolio: 70% to 100% in bonds. The primary goal is to generate dividends on stocks and interest payments on bonds. If the stock prices increase over time, even better.
Growth portfolio: 70% to 100% in stocks. The primary goal is to produce capital gains by selling stocks at a profit. The portfolio will also generate dividends on stocks and interest payments on bonds, but that’s a secondary objective.
Balanced portfolio: 40% to 60% in stocks. As the name implies, the goal is both income and growth in some combination.
Ask an investment advisor which portfolio is right for you.
Why time is an important factor
Keep in mind that younger people can afford to take more risk because the investor has more years to recover from stock market losses. A 25-year-old may invest a bigger percentage of the portfolio in stocks than a 60-year-old.
Why?
If the stock portfolio declines in value, the 25-year-old has more years to wait for a market recovery. A 60-year-old who is retiring in 5 years has less time to make up for losses.
This is true whether IBM is sold at a loss, or if the stock is held by the investor during a market decline. Younger investors have more time.
In Chapter 13, I explained that Sally (our investor) is investing $315 a month into her employer’s 401(k) retirement plan. Sally is 35 years old and decides to use a growth portfolio with 70% in stocks and 30% in bonds.