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Solid Finances Sponsors

• MSU Extension• MSU Human Resources

• This program is made possible by a grant from the FINRA Investor Education Foundation through a partnership with United Way Worldwide.

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Personal Risk Tolerance & Asset Allocation

Joel Schumacher

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Practice Question A: Your Age

1. Under 302. 31-403. 41-504. 51-605. Over 60

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Investment Risk Review

• Systematic Risks– Interest Rate Risk– Inflation Risk– Currency Risk (Exchange Rate Risk)– Liquidity Risk– Sociopolitical Risk

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Investment Risk Review

• Non-Systematic Risks– Management Risk– Credit Risk– Geographical Risk

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Question B: Is risk a bad thing?

1. Yes, it should be avoided at all times.2. Yes, but I can’t avoid it.3. Some risk is ok but too much is bad.4. No, risk helps me achieve my goals.

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Risk vs. Reward

• We can’t avoid all investment risk.

• Higher levels of risks are generally associated with higher returns over the long run.

• Asset classes have different risk levels.

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What is asset allocation?

Securities and Exchange Commission says:

“involves dividing an investment portfolio amount different asset categories”

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Goal of Asset Allocation

Risk Management

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Asset CategoriesMain Categories• Stocks• Bonds• Cash Equivalents Other Categories• Real Estate• Precious Metals

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Sub-Categories

• Small Cap Stocks• Mid Cap Stocks• Large Cap Stocks• Foreign Stocks• Emerging Markets

Stocks• Sector Stocks• Savings Bonds

• Government Bonds• Corporate Bonds• Municipal Bonds• High Yield Bonds• Commercial Real Estate• Residential Real Estate

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Risks are Correlated

• Asset Classes tend to be correlated– Stock Prices tend to move together– Bond Prices also tend to move together

• Stocks/Bonds of specific industries are correlated– Banking, Automakers, Energy Companies, etc.

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Question C: What is an investment portfolio?

1. Your IRA2. Your employer retirement account3. All of your retirement savings4. All of your savings

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Investment Portfolio

• Narrow Definition:– My IRA with XZY company– My emergency savings account

• Broader Definitions:– All of my retirement savings– My daughter’s college savings• Savings Account & Savings Bonds

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Risk and the Investment Goal

• Different investment goals have different levels of acceptable risk.– Time until the goal is often a key factor.– The alternative to poor performing investment is

also a factor.

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Investment Goals

• Common Goals:– Retirement– Home Purchase– Car Purchase– Vacation– Tuition– Emergency Account

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Risk and the Individual

• We each have different levels of risk tolerance.– Some of us are risk takers.

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Question D: Do you consider yourself a risk taker?

1. Always2. Sometimes3. Occasionally4. Rarely5. Never

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Personal Risk Tolerance Quiz• Differences:– Number of questions they ask– Type of results they provide• Asset allocation recommendations vs. Risk Score

• Which is best?– It depends.

• Solution: – Try several.

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Determining Your Asset Allocation

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How do you decide what is best for your situation?

• Step 1: Determine Your Goal?– Retirement Savings– Home Purchase– Car Purchase– Vacation– College Tuition– Emergency Savings Account

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How do you decide what is best for your situation?

• Step 2: When will this event take place?– Short Term Goals• Emergency Account might be needed on very short

notice• Car Purchase: month to years

– Longer Term Goals• Retirement Planning: months to decades away

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Risk Tolerance

• Step 3: Determine your risk tolerance.– Personal Risk Assessment Quizzes may help• Some of these tools provide “suggested allocations”

– Ask yourself “What are the consequences of poor investment returns?”

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Determine Your Allocation

• Select an Allocation based on:– Your Goal– Your Time Frame– Your Personal Risk Tolerance– Available Options

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Question E: Once you have selected an asset allocation mix, you don’t need to review it.

1. True2. False

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Question F: How often should you rebalance?

1. Once a year2. More than once a year3. Only when your goals change4. Only if your situation changes5. It depends

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Rebalancing

• You may want to rebalance when:– Your goal or time frame changes.– Your “alternative” to poor investment returns

changes– Periodically (Semi-Annually, Annually, etc.) to

account for investment returns

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Rebalancing ExampleJen inherited $10,000 •She is going to invest it for retirement

•She decided that her allocation should be:• $5,000 in Large Cap Stocks• $2,500 in Small Cap Stocks• $2,000 in Bonds• $ 500 in a Money Market Account

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Rebalancing

• Why?– Goals change– Time frame changes– Personal situation changes– Investment returns change your allocation

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Rebalancing ExampleJen’s Initial Allocation was:• 50% in Large Cap Stocks• 25% in Small Cap Stocks• 20% in Bonds• 5% in a Money Market Account

Here are 10 years of Investment Returns:

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009S& P 500 -9.11% -11.89% -22.10% 28.68% 10.86% 4.91% 15.79% 5.49% -37.00% 6.00%

Russell 2000 -3.02% 2.49% -20.48% 47.25% 18.33% 4.55% 18.37% -1.57% -33.79% 7.22%Van. Total Bond 11.39% 8.43% 8.26% 3.97% 4.24% 2.40% 4.27% 6.92% 5.05% 5.93%Money Market 2.80% 1.80% 1.40% 2.70% 2.60% 3.50% 3.20% 3.50% 1.80% 0.18%

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No Rebalancing: 2000 to 2009• Jen’s Ending Allocation was:

• 34% in Large Cap Stocks• Range: 34% to 50%

• 27% in Small Cap Stocks• Range: 24% to 32%

• 32% in Bonds• Range: 23% to 32%

• 7% in Money Market Account • Range: 4% to 7%

• Her account is worth: $11,128

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Rebalancing Annually: 2000 to 2009• Jen’s Ending Allocation was:

• 50% in Large Cap Stocks • Range: 36% to 51%

• 25.3% in Small Cap Stocks• Range: 19% to 27%

• 20% in Bonds • Range: 16% to 28%

• 4.7% in Money Market Account • Range: 4% to 7%

• Her Account is worth: $13,631

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Question G: When was the last time you rebalanced your investments?

1. I never have2. More than 5 years ago3. 1 to 5 years ago4. In the last year5. I don’t have any investments

Key Points

• Asset Allocation Depends on Several Factors

• The Goal is Risk Management

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Question H: Who is likely to take on more investment risk?

1. 50 year old, investing for a future second home purchase

2. 80 year old, investing his emergency savings account

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Question I: Which combination has the lowest risk?

1. Lowes & Home Depot stock2. Lowes & Microsoft stock3. Not Sure

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Question J: Which combination has the lowest risk?

1. Home Depot Bond & Microsoft Stock2. Home Depot Stock & Lowes Bond3. Not Sure