Dialogue on Asset Allocation
A Socratic Dialogue in which Novi and the Professor discuss Asset Allocation.
We’re back this week with another Socratic Dialogue, this time with Novi and the Professor talking about Asset Allocation.
ASSET ALLOCATION
PERSONS OF THE DIALOGUE
NOVI, a novice investor.
PROFESSOR, a wise teacher of investment topics.
SCENE: A Coffee Shop
Novi joins the Professor in the Coffee Shop, each with a coffee and a pastry.
Novi. Good morning professor.
Professor: Hello Novi.
Novi. Did you get your phone and tablet synced?
Professor (sighs). Unfortunately, some things seem to be beyond the abilities of even the gurus. They did give me a phone number to call though.
Novi. Sorry to hear that. What are we talking about today?
Professor. Asset Allocation.
Novi. I’ve heard the term, but what is it?
Professor. Do you remember the three major types of investments we talked about?
Novi. Stocks, Bonds, and Short-term investments, wasn’t it?
Professor. Yes. And sometimes we just refer to short-term investments as Cash, so you’ll hear people talk about Stocks, Bonds, and Cash.
Novi. But not Cash like paper money.
Professor. Correct.
Novi. So, does Asset Allocation have to do with how you mix these together?
Professor. Yes, you’ve got it.
Novi. People don’t seem to talk about it much. All I really hear is people talking about which stock to buy and so forth.
Professor. Unfortunately, that’s true. You rarely hear investment experts talk about asset allocation and compounding.
Novi. How come?
Professor. It’s less exciting I suppose. And, the investment gurus are really just trying to get your attention.
Novi. So, is Asset Allocation important?
Professor. Very important. It’s basically how you set your investment strategy.
Novi. Can you give me an example?
Professor. Of course. But first, do you remember when we talked about the long-term compounding rate on your portfolio.
Novi. Yes, you said your compounding rate is the most important number that determines how much money you’ll have down the road.
Professor. Correct. And do you remember the approximate long-term compounding rates for Stocks, Bonds, and Cash?
Novi. I remember that Stocks were around 10% but I can’t remember the others.
Professor. Stocks are around 10%, Bonds around 5%, and Cash around 3%.
Novi. That’s right.
Professor. Of course, these are long-term averages and returns on a year-to-year basis can be quite different, especially for stocks.
Novi. And I know you’re always banging on about how important Time is when evaluating investments.
Professor. Very true.
Novi. So, if I have this right, your Asset Allocation will affect your long-term compounding rate.
Professor. Yes, and this is a big deal. Remember when we talked about compounding we figured out that if you invest $10,000 and earned 10% for 40 years it would be worth about $453,000.
Novi. Yeah, that was amazing. And you said if you compounded it for 50 years it would be over $1 million.
Professor. That’s right. So if the $10,000 would grow to $453,000 at 10 %, can you guess what it would grow to at 5%?
Novi. I’m guessing around half of that, maybe $225,000.
Professor. Not even close. It would be about $70,000.
Novi. That’s weird.
Professor. Remember, we’re talking about exponential growth so things don’t go in a straight line the way you might expect.
Novi. So, what would it be if the money grew at 3%?
Professor. About $33,000.
Novi. Wow, that’s a huge difference.
Professor. That’s why the compounding rate and your Asset Allocation—which is the main determinate of your compounding rate—is so important.
Novi. It’s strange that nobody really talks about it.
Professor. True, but the managers of your retirement funds are paying attention to it. You have a 401(k) plan at work and I’m guessing you’re invested in a Target Date Fund.
Novi. I think so.
Professor. Then one of your homework assignments is to check it out.
Novi. OK, I’ll do that.
Professor. One nice thing about a Target Date Fund is that the managers of the fund do the Asset Allocation for you based on best practices and based on your age.
Novi. So, what kind of Asset Allocation would they have for me?
Professor. You’re young, so which asset class do you think they would favor, Stocks, Bonds, or Cash?
Novi. I would think Stocks.
Professor. Yes. And if you take a look, I expect the Target Date Fund you’re in will have roughly a 90% allocation to stocks and 10% allocation to Bonds.
Novi. Would it make sense to have a higher allocation to Stocks?
Professor. Excellent question. And you can, of course, adjust your Asset Allocation to what you want it to be. For someone your age, it might not really make sense to include Bonds because they will lower your compounding rate in the long run.
Novi. So, why are Bonds included in my allocation.
Professor. Probably just for optics. It might seem like something smart to do given how volatile Stocks can be in the short term.
Novi. But you keep saying I should ignore the short-term ups and downs in the stock market.
Professor. That’s true, but it’s a human nature thing. Until you fully understand the process, it’s hard to trust that it will work out. When the stock market goes down—and your 401(k) balance goes down—it’s natural to be concerned.
Novi. OK, so when does it make sense to have less in Stocks?
Professor. Let me ask it this way. What do you think your Stock allocation should be when you reach retirement?
Novi. Zero?
Professor. Do you think you stop investing when you retire?
Novi. I suppose not. I hope to live a long time in retirement.
Professor. Correct. So, when you reach retirement, you need some money invested in short-term assets (Cash and short-term Bonds) but you still need some money invested in Stocks in order to grow and give you the money you’ll need later in retirement.
Novi. That makes sense. So, what allocation should I have in Stocks when I retire.
Professor. Most Target Date Funds will shoot for somewhere between 50% and 60% in Stocks at retirement and then gradually go down from there.
Novi. OK and thanks for helping me understand Asset Allocation better. I’m sure I’ll have more questions, but I need to run for now.
Professor. You’re welcome, Novi. Taking time to learn more about investing is one of the smartest things you can do to make sure you are financially secure and can spend more time enjoying what you like to do.
Novi. I appreciate all your help. Enjoy the rest of your day.
Professor. You too.
As was the case last week, we’re experimenting with the idea of using Socratic Dialogues to explore investment topics. If you like these, let us know.
Best regards,
Stuart & Sharon