People like a winner. They also like a sure thing. That is why so many private investors saving for retirement leave their money in the same investments that were last year’s strong players.
It makes sense. It can also be a really big mistake, according Gregory Friedman, a certified financial planner and CEO and president of Private Ocean in San Rafael and Walnut Creek, Calif. He calls it investor greed.
“The desire to always go to last year’s winners is so strong and so consistent. it’s like a siren’s call,” Friedman said. But investments, like the market itself, rise and fall. The key is to make investment decisions – your “asset allocations” – based on a long-term strategy; and to frequently “rebalance” where you put your money in order to compensate for those peaks and valleys. If you do both right, you should come out a winner when it comes time to live off those earnings.
Q: We hear the terms asset allocation and portfolio rebalancing used together. What is meant by each, and how do the terms relate?
Friedman: I think of asset allocation as the strategic setting of what assets, and then what percentages you want those assets to represent that will be included in a portfolio. Portfolio rebalancing is different. That is the systematic or periodic return of the asset allocation to the targets or the percentages originally set. One is setting them and what can be included in them and the other is how you get back to them. Markets move and you move off those targets fairly quickly.
Q: What is the goal with an asset allocation strategy?
Friedman: Simply stated, the goal of an asset allocation strategy is to get a desired return with the minimum risk, and that return that you are trying to get can absolutely be determined by an individual’s personal financial planning circumstances.
Q: What are the elements of an asset allocation strategy?
Friedman: Its determining what asset classes to include – which are appropriate and which ones do you want to include; what is the desired and/or required rate of return; what is the individual’s risk tolerance; what is their risk capacity (which is something I’ll define later); what is their income tax situation; and beyond that, what individual investment vehicles will be used to represent those various asset classes.
Q: You just used the terms risk tolerance and risk capacity. Please explain what those are?
Friedman: Risk tolerance is really the ability for an investor to emotionally “stay on their feet”, so-to-speak. As your portfolio fluctuates or as an investment fluctuates it’s the ability not to panic or abandon their investment strategy. Risk capacity is really more of a financial planning concept: what is your capacity to absorb risk from a financial perspective.
Said another way, if I am infinitely wealthy and my lifestyle expenses are very small, my financial risk capacity is very high. I can afford to take huge risks with my investments because no matter what happens, I’m good. To contrast that, other people spend a great deal, they demand a lot from their existing resources, and they withdraw quite a bit from their portfolio – their risk capacity is quite low. They really can’t afford to take huge risks because it would mean a certain change in lifestyle.