The market has dropped and many seem to have the answers now, in retrospect of course, and we may turn to them and say - So you are a big shot now? But basically what has happened is that they have ignored the advice of the Three Wise Men of Finance. While portfolio theory can get a bit complex, its basic message that in order to reduce risk a portfolio should contain investments that are not correlated to each other. For instance, if you own Dell and HP or Exxon Mobil and Shell, you can clearly see that these stocks will be correlated to what happens in the industry. To dispel more complexity, it is clear that stocks and bonds are not correlated, at least in most market conditions. So a properly diversified portfolio should reduce the exposure to risk.
Today, a retiree who was 100% invested in stocks would have lost 40-50% of his or her portfolio. A 50%:50% stock/bond portfolio would have lost about 20% and a 40:60 stock/bond portfolio would have lost about 16%. Rule of thumb is that investors should have a percentage in bonds the equivalent of their age. So, if you are 70 years old then you should be 30% invested in stocks and 70% in bonds and cash. However, these rules of thumb cannot be applied across the board. That is the reason why financial professionals repeat the fact that each person’s situation is unique.
For instance, if you take two people A & B, both 70 years old who have different net-worth but maintain the same standard of living the rule of thumb may not apply. A has $1 million and B has $5 million. B feels that his $2 million in cash and bonds is enough of a cushion for him to live another 50 years. He intends to keep the remaining $3 million for others to inherit and some favorite charities, thus that $3 million portion is invested exclusively in stocks. B’s stock/bond portfolio is 60% stocks and 40% bonds, the rule of thumb which applies to a 40-year old person.
Anyway, assuming that we are dealing with a normal situation, if A was invested 100% in stocks his portfolio would be in the range of $500,000-600,000 at end 2008; 50% in stocks and his portfolio would probably be about $800,000, and 40% in stocks and his portfolio would be worth about $840,000. This shows how important diversification is.
Several years ago I bumped into a gentleman who had much commonsense about finance. While a financial planner was trying to suggest exotic financial instruments to a friend of his, he posted this question. Harry he said. From what I know of you and how you live, your savings will enable you to live at least 300 years or so. So why even bother about the stock market and risk all you’ve got. Great advice I think. Sometimes, cash is king if you don’t need it to grow and you have sufficient to last you way beyond your years. Of course, such advice would not hold well if inflation is rampant, like a thousand percent a year in some countries.
No doubt, diversification pays, and this financial tsunami has taught investors a great lesson. If you want to get into the deeper study of diversification and related correlatively please review Modern Portfolio theory.
On the other hand, if you were already smart and say had $1 million or other equivalent amount and was invested 50% in stocks and 50% in bonds at the start of 2008. Then, at the end of 2008 your stock portion will be down 37-40% (lets assume 40%) or it will be worth about $300,000 and your bond portfolio will still be about $500,000, so you lost about $200,000 (20%) on your total portfolio. Therefore you allocation mix now stands at 30% stocks and 70% bonds. If you intend to keep the 50%:50% mix then it is a good time to re-balance and sell some bonds and buy stocks to get back to your allocation mix. On the other hand, if you were overrepresented in stocks before and you now feel comfortable with the new mix, then leave it alone. never underestimate the costs associated with asset allocation in mutual funds.
I only wish that do-it-yourself investors learn from their mistakes and not foul things any further. The big problem with the world wide web is that stupid mistakes are only one click away. Just like children having fun in the sea surf other adults can make missteps in the web surf. So be careful before you hit that buy or sell button or let some finance professional take you for a jolly good ride. Even very sophisticated investors were fooled by Bernard Madoff.
References to Personal Finance are strictly for "educational purposes" and does not hint or offer any specific financial or tax advice. For financial advice, please seek the advice of a professional if you feel unable to handle your own finances/taxes
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