Best Practices

Personal Finance 101

By Neil G. Cohen, Associate Professor of Finance
Published: Spring 2010

Professional people beware! Your sophistication likely does not extend to managing your money. To keep rooted and rational during this period of financial meltdown and partial recovery ─ and to avoid emotional traps  remind yourself about the time-tested principles of investing.

The elements of a personal investment plan are straightforward:

1.How many years will it be until you need to withdraw how much money for education, retirement, etc.?

2.How is the portfolio allocated among cash equivalents, bonds and stocks?

3.What rate of return can reasonably be earned on the portfolio each year?

4.How much money is in the portfolio now, and how much in savings must be added each year to meet the requirements in Question No. 1?

If you don’t know the answers to these four questions, you flunk this simple money management IQ test. You also have work to do.

Time Horizon

“It’s not timing the market, but the amount of time you are in the market, that counts.” Attributed to Peter Lynch, a king of money management, this quote simply states that the longer the time horizon, the better. Stock market ups and downs can’t be predicted or timed. A long horizon insulates against market volatility and provides the greatest chance of achieving the desired rate of return.

Not all time frames are the same. An education fund with a short-time horizon is invested differently than a retirement fund with a long-time horizon.

Asset Allocation

The proportion of assets you should have in each asset class – stocks, bonds, cash equivalents and real estate – depends on your time horizon. As you age, you should reduce volatile equities and increase the proportion of more stable bonds. Rebalance your portfolio every year. The table below can be used as a guide.

Asset Class Mid-Twenties Thirties-Forties Mid-Fifties Late Sixties+
Stocks 65% 60% 50% 35%
Bonds 20% 25% 32.5% 40%
Cash 5% 5% 5% 10%
Real Estate 10% 10% 12.5% 15%
Total 100% 100% 100% 100%

From: A Random Walk Down Wall Street, Burton Malkiel, W.W. Norton, 2007

Best practice instructs that buy-hold index investing outguns stock picking and market timing. Most of the rate of return, at least 90 percent, is attributable to how your money is divided among cash equivalents, bond market index funds and stock market index funds. Less than 10 percent of the rate of return comes from picking individual securities. The best advice is to put money into index funds in each of the asset classes and rebalance every year, depending on your time horizon, according to the table above.

Do you want to time the market, selling at the top and buying at the bottom? Can you predict the tops and bottoms? Few can; it’s better to be a buy-and-hold investor. A study of market timing by American Century Investments found that missing the best 10 days of the S&P 500 Index performance, from 1991 through 2006, cut 38 percent out of a portfolio’s accumulation. Missing the 50 best days reduced it by 82 percent. Many studies conclude that buy-hold investors achieve better results than market timers.

Rate of Return

Adjustments are part of investing. The California Public Employees’ Retirement System, one of the biggest and best-managed funds in the world, previously targeted an average 7.75 percent annual rate of return. Now, it is considering revising this target rate of return down to 6 percent, a reduction of 25 percent.

Earning, Spending, Saving and Taxes

You might say it’s too hard to save now, that you’ll save plenty when the kids are older, that there’s lots of time to grow the money from age 50 on. Let’s test that:

  • $25,000 saved each year for 10 years at a 10 percent rate of return accumulates to about $398,000.
  • $3,600 saved each year for 35 years at a 6 percent rate of return accumulates to about $400,000.

Small, slow, steady savings with modest returns can match larger, faster savings at a much higher rate of return. The longer you wait to save, the higher the rate of return and the greater risk you will face to grow your portfolio. A 10 percent annual return might not be achievable.

Where Are All the Customer’s Yachts?

A book with this title published in 1940 continues to offer good advice by posing the question: Who is richer, you or your financial adviser? Don’t cede too much control to your financial adviser, who may not get paid unless you trade.

Know the principles of investing. Have a plan, in writing. Stick to it. Once your education fund and retirement fund are in place, and you still itch to try your hand as a stock-picking, market-timing hobbyist, set up a third fund with money you can afford to lose and enjoy yourself  but not with your serious money. GW