Developing Your Asset Allocation Strategy for Retirement

Developed by Barbara O’Neill, Ph.D., CFP, Rutgers Cooperative ExtensionAdapted by Jean Lown, Ph.D.

Family, Consumer & Human DevelopmentLown@cc.usu.edu

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Overview

● Asset Allocation Principles● Risk-Return Relationship● Application to TIAA-CREF

Retirement Investment Options » 9 new investment choices (as of

2003)

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What Is Asset Allocation?

● Process of diversifying portfolio investments among several investment categories to reduce investment risk

● Example: 50% stock, 30% bonds, 10% real estate, 10% cash assets

● Objective: lower investment risk by reducing portfolio volatility

● Loss in one investment may be offset by gains in another

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The Callan Periodic Table of Investment Returns

● http://www.callan.com/resource/periodic_table/pertbl.pdf

● Illustrates the need for asset allocation

● Shows how various asset classes performed during the last 20 years

● Best performing asset class changes

● One year’s “winner” can be next year’s “loser,” so invest in a variety of assets

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Why Asset Allocation? Because Market Timing is Futile

● Value of $100 invested in large company stocks (S&P 500 index) from June 1980 to June 2000:

» $2,456 stayed invested entire time

» $613 if you missed the best 15 months

● Biggest market gains are often concentrated in short periods (can’t afford to miss)

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Second Example: The Futility of Market Timing

● Based on S&P 500 stock market index

● If investor stayed fully invested, return was 41.4%

● If investor missed top 10 trading days of 1998, 1999, and 2000: -41.7% return

● Moral: stay invested in both bull & bear markets

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Determinants of Portfolio Performance

Asset Allocation

91.5%

Other2.1%

Market Timing1.8%

Security Selection

4.6%

Source: “Determinants of Portfolio Performance II, An Update” by Gary Brinston, Brian D. Singer and Gilbert L. Beebower, Financial Analysts Journal May-June 1991

For illustrative purposes only. Not indicative of any specific investment.

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The Importance of Asset Allocation

● Asset allocation is the MOST important decision an investor makes (i.e., buying some stock, NOT Coke versus Pepsi)

● Asset allocation determines about 90% of the return variation between portfolios

● This study has been repeated numerous times, by different researchers, with similar results.

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Downside of Asset Allocation

● A diversified portfolio MAY generate a lower rate of return when compared to a single “hot” asset class (e.g., growth stocks from 1995-99) BUT

● You never know the “hot” asset class in advance (i.e., Callan table)

● Asset allocation reduces volatility to provide a competitive rate of return

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Factors To Consider

● Investment objective (e.g., retirement)

● Time horizon for a goal (e.g., life expectancy for retirement)

● Amount of money you have to invest

● Your risk tolerance and experience

» Caution about risk tests

● Your age and net worth

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Major Asset Classes

● Stocks » Large company

growth & value» Mid cap growth &

value» Small growth & value» International

● Bonds» Domestic » International» Corporate» Municipal

● Real estate (e.g., REITs)

● Cash (CDs, I-bonds, MMMFs, Treasury bills)

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Historical Average Annual Rates of Return

● Small Co. U.S. stocks = 12.6%● Large Co. U.S. stocks = 10.4%● Government Bonds = 5.1%● Treasury Bills = 3.8%● Inflation = 3.1%

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Stock Capitalization

● Large Cap companies: valued at >$5 billion » ExxonMobil, General Electric, Microsoft

● Mid-Cap: $1-5 billion » Bath & Beyond, Monsanto, Hilton Hotels

● Small-Cap: <$1 billion » Earthlink, FirstFed Financial, Vintage

Petroleum

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Why Invest Internationally?

● Correlations among world markets are low (e.g., U.S. and foreign stocks)

● World markets (especially small companies) are driven by local dynamics

● Investing in U.S. multinationals does not deliver the same level of diversification

● The benefits of diversification outweigh currency, market, & political risks

● U.S. accounts for less than 1/3 of the world’s equity (stock) markets

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Other Things to Know About Asset Allocation

● Portfolio risk decreases as the # of asset classes increases

● Best results are achieved over time● Diversify holdings within each asset

category» Stock: different industry sectors» Bonds: different types and maturities

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RISK

● Is a 4 letter word● Remember

2000-2003? » S&P 500 lost 40%

of its value

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Risk-Return Relationship

● Low risk = low return● High risk = possibility of high return● Risk: chance of loss of principal in the

short run » 2000-2003 most U.S. stocks lost

value (after incredible run-up in prices in 1990s)

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Relationship Between Risk and Return

Risk HighLow

Expected Return

High

Low

CashEquivalents

U.S. Bonds

Int’l Bonds

Real Estate

U.S. Stocks

Int’l Stocks

For illustrative purposes only. Not indicative of any specific investment.

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Diversification From Combining Investments

Investment A

Investment B

Portfolio 1

No Diversification

Investment C

Investment D

Portfolio 2

Complete Diversification

Investment EPortfolio 3

Investment F

Some Diversification

For illustrative purposes only. Not indicative of any specific investment

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Stocks are Risky in Short Run

● Very volatile in sort run (1-5 years)» annual returns -50% to +50%!! » Remember 2000-2003?» 2003 was a great year to buy stocks

when all news was gloom & doom● Large Co. U.S. stocks = 10.7% (avg.

returns since 1926)

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Time Horizon for Retirement?

● Until the day you retire? ● Until the day you die?

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Invest for Growth ● There is no such thing as a risk-free

investment!● Retirement $ must grow faster than

inflation to provide financial security» Average inflation = 3.1%

● Risk is relative» Short term volatility=long term growth» Invest in stocks for growth

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Recent Example

● 2000-2003 was a gut check● Thank goodness some of my portfolio

was in bonds & real estate!» Stocks tanked» Bonds held steady» Real estate saved the day

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“Safe” Investments are Risky in the Long Run

● Inflation = 3.1%● Government Bonds = 5.1% -3.1% = 2%● Treasury Bills = 3.8% - 3.1% = 0.7%● Subtract the impact of taxes and ‘safe’

investments yield negative returns● You will not reach your goal with low risk

investments

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Understand Risk Tolerance

● Beware of taking risk tests and settling for a conservative portfolio

● Conservative investors risk outliving their assets

● Life expectancy calculators» http://www.ces.purdue.edu/retirement/Module1/module1b.html

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The Asset Allocation Process

● Define goals and time horizon

● Assess your risk tolerance

● Identify asset mix of current portfolio

● Create target portfolio (asset model)

● Select specific investments

● Review and rebalance portfolio yearly

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Tips For Funding a Tax-Deferred Employer Plan

● Diversify across asset classes● Avoid market timing● Choose investments with good historical

performance » Past returns are NO guarantee for the

future!!» <10 year track record is too short!

● Choose funds with low fees

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The Big Picture

● Same principles can be applied to » 401(k) plans» Individual retirement accounts (IRAs)» Other retirement plans

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Questions?

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5 TIAA-CREF Asset Classes

● Guaranteed (low risk; low return)● Fixed-Income (bonds)● Equities (stocks)

» High return; volatile in the short run● Real Estate

» Inflation protection; reduce volatility● Money Market (safe but very low return)

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Global vs. International

● Global: U.S. and foreign investments● International: “all” foreign

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TIAA-CREF Options (pre-2003)

● TIAA Traditional● TIAA Real Estate● CREF Money

Market● CREF Social

Choice (bond & stock)

● CREF Stock● Global Equities● Growth● Equity Index

» LOTS of overlap!

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9 New Fund Choices (2003)

● Real Estate Securities

● Growth & Income● S&P 500 Index● Large Cap Value● Social Choice

Equity

● Mid-Cap Value● Mid-Cap Growth ● Small-Cap Equity● International Equity

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Murky Mixture

● Few of the CREF funds are “pure”● CREF Stock

» 80% Large-, 15% Mid-, 5% Small-Cap» Some foreign stocks

● Mid-Cap Growth» 59% Large-! 39% Mid-, 2% Small-Cap

● Read Prospectus (or at least the summary)

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Growth Portfolio: 3 asset classes

● STOCKS for growth» Large-cap Domestic» 10-15% Mid-Cap » 10-15% Small-cap» 10-15% International

● 10-15% Real Estate (to beat inflation)● 10-15% Bonds (to dampen volatility)

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New Funds Offer Diversity

● Lots of different stock accounts DO NOT mean diversification (overlapping)

● International Equity● Small-cap Equity ● Real Estate Securities (to complement

TIAA Real Estate)

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Your “Action” List● Review your current asset allocation● Consider your other retirement accounts ● Use the TIAA-CREF web site● Understand risk-return relationship● Talk with a TIAA-CREF rep (at USU)● Sign up for automatic rebalancing

» Limits on moving $ out of TIAA● Re-visit, Reallocate, Rebalance

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Key Considerations For Successful Investing

● Educate yourself to make informed decisions

● Establish policies and objectives

● Monitor investment performance

● Stick to your plan and stay focused

● If you need help, seek professional advice

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Financial Planning for Women

● Second Wednesday of the month» 12:30-1:30 in Family Life 318

– bring your lunch» 7-8:30 p.m. at Family Life Center (500 N &

700 E – bottom of Old Main Hill)» February 8 FPW: Investment Basics

● For mo. email news & reminder: Sign up sheet or send email to Lown@cc.usu.edu

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Questions? Comments? Experiences?

Baby Boomer Women Retirement StudyUSU IRB approved researchStep 1: Survey- return by Feb 3 for prize drawingStep 2: Focus Group ($25 compensation)

February 8 FPW: Investment Basics