Chapter 14 A Life-Cycle Guide to Investing Basics: age & income & specific responsibilities in life matter in the mix of assets in one’s portfolio. Five principles to allocate assets: 1. Risk & Reward Higher risk is the price for more returns 2. Actual risk in stocks & bonds depends on the length of time you hold them – staying power. The longer time you can hold, the greater should be the share of common stocks. 3. Dollar-cost averaging – Periodic investments of equal dollar amounts Drawback: (a). commission fee is high (b). unlikely to provide highest return 4.
Rebalancing can help reduce investment risk and increase returns – Bringing the proportions of your assets devoted to different asset classes back into the proportions suited to your age and your attitude toward and capacity for risk. 5. Distinguish between attitude toward and capacity for risk – usually related to age Three Guidelines for a Life-Cycle Investment Plan: 1. Specific assets for specific needs – set aside certain amount of money in a safe security 2. Know your tolerance for risk – the risk in equities is reduced the longer time period you hold them. 3.
Persistent saving – accumulate your savings, no matter how small. The life-Cycle Investment Guide: – More aggressive investment portfolio is recommended as the age of a person decreases. – Broad-based, total stock-market index funds rather than individual stocks for portfolio formation is recommended. Resons: 1. most people do not have sufficient capital to diversify properly. 2. most younger people will not have substantial assets and will be accumulating portfolios by monthly investments. Life-Cycle Funds: -A way to avoid the hassle of adjusting the portfolio as you age and rebalancing yearly automatically. The equity mix will become more conservative over time. -Always check fee schedule Annuities – ‘long-life insurance’- contracts made with an insurance company where the investor pays money to guarantee a series of periodic payments that will last as long as the annuitant lives. ADV: guarantees that you will not outlive your money DISADV: inconsistent with bequest motives/lacking flexibility of consumption/costly/taxable Do-It-Yourself Method – The 4-half percent solution: Two reasons to limit the take-out rate: 1. preserve the ability to allow your monthly payments to grow over time of inflation. . ensure that you could ride out of inevitable bear markets. Other rules: let the amount you take out grow by 2% per year/rebalance and keep the risk level/tap assets to defer paying income taxes Three ways to go about buying stocks The No-Brainer Step: Investing in Index Funds – The Most Highly Recommended The logic – the efficient-market theory – ADV: 1. Index funds have regularly produced rates of return exceeding those of active managers Reason: Small management fees and trading costs 2. Tax-friendly Reason: they allow investors to defer or completely avoid the realization of capital gains 3.
Relatively predictable 4. Easier to evaluate – Broad diversification rules out extraordinary losses and also, gains. However, it doesn’t rule out risks (if the market goes down, your portfolio is guaranteed to follow suit). – Other ADVs especially for small investors: 1. obtain very broad diversification with only a small investment 2. allow you to reduce brokerage charges – A broader definition of index Why broader? 1. The former S&P indexing strategy has become so popular that it may have affected the pricing of the component stocks in the index. 2. Smaller stocks have tended to outperform larger ones.
ETFs – More tax-efficient – deliver low-cost shares against redemption requests – Excellent vehicle for investment of lump sums to be invested in index funds – However, still requires transaction costs The Do-It-Yourself Step: Rule1: Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years. Rule 2: Never pay more for a stock than can be justified by the firm’s foundation value. Rule 3: Buy stocks with stories that can attract investors (castle in the air) Rule 4: Trade as little as possible to avoid transaction fees.
The Substitute-Player Step – hiring a professional Wall St Walker: – Good: Picking from active mutual-fund managers frees one from having to select stocks and doing paperwork and records for tax purpose. Bad: difficulty in choosing the investment managers – you cannot depend on an excellent record continuing persistently in the future. -The Morningstar Mutual-Fund Info. Services What’s Morningstar? – provides you with the most comprehensive sources of mutual-fund information/also uses a five-star rating system to evaluate, though not always true. -Mutual-Fund Costs: 1. Leading Fees – front-end load/Back-end loads and exchange fees 2.
Expense Charges – Operating and investment management exp. /12b-1 charges *. Mutual-fund asset performance bears no relationship to the exp charged Avoid funds with high turnovers – The Malkiel Step Buy highly discounted closed-end funds – even if the discouns remained at high levels, investors would still reap high rewards from the purchases. (Closed-end funds: they neither issue nor redeem share after the initial offering) *. up to now, most domestic closed-end funds are no longer an esp. attractive opportunity >Paradox about the usefulness of investment advice concerning specific securities BUT: une