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Asset Allocation For Dummies®

Book Description

An easy-to-understand how-to guide to the single most important thing you can do in investing — choosing and mixing your assets successfully.

You don't need to be an expert analyst, a star stock-picker, or a rocket scientist to have better investment results than most other investors. You just need to allocate your assets in the right way, and have the conviction to stick with that allocation.

The big secret behind asset allocation — the secret that most sophisticated investors know and use to their benefit — is that it's really not all that hard to do.

Asset Allocation For Dummies serves as a comprehensive guide to maximizing returns and minimizing risk — while managing taxes, fees and other costs — in putting together a portfolio to reflect your unique financial goals.

Jerry A. Miccolis (Basking Ridge, NJ), CFA®, CFP®, FCAS, MAAA is a widely quoted expert commentator who has been interviewed in The New York Times and the Wall Street Journal, and appeared on CBS Radio and ABC-TV. He is a senior financial advisor and co-owner of Brinton Eaton Wealth Advisors (www.brintoneaton.com), a fee-only investment management, tax advisory and financial planning firm in Madison, N.J. Dorianne R. Perrucci (Scotch Plains, NJ) is a freelance writer who has been published in The New York Times, Newsweek, and TheStreet.com, and has collaborated on several financial books, including I.O.U.S.A, One Nation, Under Stress, In Debt (Wiley, 2008).

Table of Contents

  1. Copyright
  2. About the Authors
  3. Acknowledgments
  4. Publisher's Acknowledgments
  5. Introduction
    1. About This Book
    2. Conventions Used in This Book
    3. What You're Not to Read
    4. Foolish Assumptions
    5. How This Book Is Organized
      1. Part I: Discovering the Not-So-Secret Recipe for Asset Allocation
      2. Part II: Getting Started
      3. Part III: Building and Maintaining Your Portfolio
      4. Part IV: Going beyond the Basics
      5. Part V: The Part of Tens
    6. Icons Used in This Book
    7. Where to Go from Here
  6. I. Discovering the Not-So-Secret Recipe for Asset Allocation
    1. 1. Understanding Asset Allocation
      1. 1.1. Figuring Out Why Asset Allocation Is So Important
        1. 1.1.1. Encapsulating the Enron story
        2. 1.1.2. Exploiting the 90 percent solution
      2. 1.2. Uncovering the Basics of Asset Allocation
        1. 1.2.1. Balancing risk and return
        2. 1.2.2. Selecting your asset classes
        3. 1.2.3. Determining your asset mix
        4. 1.2.4. Rebalancing your asset mix
      3. 1.3. Getting Started with Your Investment Strategy
      4. 1.4. Building Your Portfolio and Keeping It True to Your Long-Term Goal
        1. 1.4.1. Selecting securities
        2. 1.4.2. Mastering asset location
        3. 1.4.3. Monitoring your portfolio to stay on target
        4. 1.4.4. Measuring your results
      5. 1.5. Reaching Past the Asset Allocation Basics
        1. 1.5.1. Adding alternatives
        2. 1.5.2. Tackling taxes
        3. 1.5.3. Altering your allocation
        4. 1.5.4. Embracing expert help
    2. 2. Weighing Risk and Return
      1. 2.1. Measuring Return
        1. 2.1.1. Total return and its components
        2. 2.1.2. Nominal return versus real return
        3. 2.1.3. Understanding time-weighted return versus dollar-weighted return
        4. 2.1.4. Annualizing multiyear returns
        5. 2.1.5. Accounting for taxes, fees, and expenses
          1. 2.1.5.1. Considering the taxes that affect your investment returns
          2. 2.1.5.2. Understanding fees and expenses
      2. 2.2. Measuring Risk
        1. 2.2.1. Differentiating between volatility and risk
        2. 2.2.2. Understanding how volatility erodes return: Risk drag
        3. 2.2.3. Using statistical measures for risk
          1. 2.2.3.1. Range
          2. 2.2.3.2. Standard deviation
        4. 2.2.4. Factoring in your time horizon
      3. 2.3. Evaluating the Trade-Off between Risk and Return
        1. 2.3.1. Recognizing that there's (usually) no such thing as a free lunch
        2. 2.3.2. Heading for the efficient frontier
    3. 3. Making Sense of Asset Classes
      1. 3.1. Identifying the Traditional Classes
        1. 3.1.1. Embracing equities: Stocks and stock funds
          1. 3.1.1.1. Size
          2. 3.1.1.2. Sector
          3. 3.1.1.3. Style
        2. 3.1.2. Getting a handle on fixed-income investments: Bonds, bond funds, and more
          1. 3.1.2.1. Understanding how bonds work
          2. 3.1.2.2. Exploring the three major types of bonds
            1. 3.1.2.2.1. U.S. government bonds
            2. 3.1.2.2.2. Municipal bonds
            3. 3.1.2.2.3. Corporate bonds
          3. 3.1.2.3. Getting familiar with bond mutual funds
          4. 3.1.2.4. Considering other types of fixed-income investments
            1. 3.1.2.4.1. Mortgage-backed securities
            2. 3.1.2.4.2. Collateralized debt obligations
            3. 3.1.2.4.3. Preferred stocks
            4. 3.1.2.4.4. Convertible bonds
          5. 3.1.2.5. Checking up on a bond issuer's credit
          6. 3.1.2.6. Laddering by maturity
        3. 3.1.3. Capitalizing on cash and cash equivalents
          1. 3.1.3.1. Certificates of deposit
          2. 3.1.3.2. Money-market deposit accounts
          3. 3.1.3.3. Money-market mutual funds
      2. 3.2. Understanding Alternative Investments
        1. 3.2.1. Looking at your options for alternative investments
          1. 3.2.1.1. Investment real estate
          2. 3.2.1.2. Hard assets (commodities)
          3. 3.2.1.3. Hedge funds
        2. 3.2.2. Knowing when to add alternative investments to your portfolio
      3. 3.3. Going Global with International Investments
    4. 4. Determining the Right Proportions: Your Asset Mix
      1. 4.1. Putting the 90 Percent Solution to Work for You
        1. 4.1.1. Keeping your eye on the important 90 percent: Allocating your assets
        2. 4.1.2. Avoiding focusing on the other 10 percent
        3. 4.1.3. Embracing asset allocation's guiding principle
      2. 4.2. Laying the Foundation for Successful Asset Allocation
        1. 4.2.1. Understanding correlation
        2. 4.2.2. Discovering the appeal of non-correlated assets
          1. 4.2.2.1. Understanding non-correlated assets
          2. 4.2.2.2. Finding non-correlated assets
          3. 4.2.2.3. Realizing how 2 + 2 can equal 5 in your portfolio
          4. 4.2.2.4. Making Rudolph the Red-Nosed Reindeer work for your portfolio
        3. 4.2.3. Finding the holy grail of asset allocation: Perfect negative correlation
        4. 4.2.4. Seeking stability and vanquishing volatility
          1. 4.2.4.1. Appreciating the virtue of stability
          2. 4.2.4.2. Avoiding the cost of volatility
      3. 4.3. Recognizing the Most Important Features of an Asset
    5. 5. Stirring the Mix: Portfolio Rebalancing
      1. 5.1. Getting Your Free Lunch with Rebalancing
      2. 5.2. Understanding the Power of Rebalancing
        1. 5.2.1. How rebalancing works: Unlocking the energy of the periodic table
        2. 5.2.2. Making volatility work for you: Volatility pumping
        3. 5.2.3. Memorizing the mantra: How rebalancing forces you to buy low and sell high
        4. 5.2.4. Being a contrarian: Making sure you have the right mindset for rebalancing
      3. 5.3. Following the Right Rebalancing Schedule
        1. 5.3.1. Rebalancing on fixed calendar dates
        2. 5.3.2. Planning your rebalancing for the greatest opportunity
  7. II. Getting Started
    1. 6. Laying the Foundation for Your Plan
      1. 6.1. Seeing Your Investment Horizon Clearly
      2. 6.2. Setting Your Return Objectives
      3. 6.3. Making Decisions about Your Risk Tolerance
        1. 6.3.1. Evaluating your experience
        2. 6.3.2. Considering risk questionnaires and other tools
      4. 6.4. Setting Your Portfolio Constraints
        1. 6.4.1. Recognizing positions you won't get out of
        2. 6.4.2. Identifying investments you won't consider
        3. 6.4.3. Limiting your exposure to certain asset classes
      5. 6.5. Reviewing Your Tax Situation
        1. 6.5.1. Being mindful of your current and future tax brackets
        2. 6.5.2. Looking for opportunities in prior tax returns
        3. 6.5.3. Considering which of your assets are in tax-deferred accounts
      6. 6.6. Taking Account of Special Circumstances
        1. 6.6.1. Protecting your assets from lawsuits
        2. 6.6.2. Protecting your estate from taxes
        3. 6.6.3. Simplifying your holdings
    2. 7. Developing Your Investment Strategy
      1. 7.1. Understanding the Lifetime Cash-Flow Projection
        1. 7.1.1. Getting a feel for the basics
        2. 7.1.2. Recognizing the link between your asset allocation and your Lifetime Cash-flow Projection
      2. 7.2. Coming Up with an Outline for Your Long-Term Financial Plan
        1. 7.2.1. Assets
        2. 7.2.2. Liabilities
        3. 7.2.3. Income
          1. 7.2.3.1. Compensation: Wages, salaries, and bonuses
          2. 7.2.3.2. Pensions and retirement account distributions
          3. 7.2.3.3. Stock options
          4. 7.2.3.4. Annuities
          5. 7.2.3.5. Social Security
          6. 7.2.3.6. Withdrawals
        4. 7.2.4. Expenses
          1. 7.2.4.1. Annual living expenses
          2. 7.2.4.2. Loan payments
          3. 7.2.4.3. Medical care
          4. 7.2.4.4. Education costs
          5. 7.2.4.5. Weddings, vacations, and other special events
          6. 7.2.4.6. Taxes
          7. 7.2.4.7. Savings
      3. 7.3. Putting It All Together: Making Lifetime Cash-Flow Projections
        1. 7.3.1. Salary and other income
        2. 7.3.2. Expenses
        3. 7.3.3. Investment returns
        4. 7.3.4. Taxes
        5. 7.3.5. Savings or withdrawals
        6. 7.3.6. Assets
        7. 7.3.7. Liabilities
      4. 7.4. Testing "What If" Scenarios
        1. 7.4.1. What if you retire early?
        2. 7.4.2. What if you start a family or have more children?
        3. 7.4.3. What if you want to change your career?
      5. 7.5. Determining How Your Asset Allocation May Affect Your Lifetime Cash-Flow Projection
        1. 7.5.1. Estimating returns
        2. 7.5.2. Reckoning risk
        3. 7.5.3. Working risk and return into your Lifetime Cash-flow Projection
      6. 7.6. Documenting Your Strategy: Drafting Your Investment Policy Statement
    3. 8. Creating Your Allocation Plan
      1. 8.1. Selecting Your Asset Classes
      2. 8.2. Establishing Your Asset Class Mix
        1. 8.2.1. Go long! Finding percentages for the long haul
        2. 8.2.2. Picking the right percentages
          1. 8.2.2.1. How the pros do it
          2. 8.2.2.2. How you can do it
      3. 8.3. Looking at Some Sample Allocation Percentages
        1. 8.3.1. Aggressive: Higher equity percentage
        2. 8.3.2. Conservative: Higher fixed-income percentage
        3. 8.3.3. Moderate: Right in the middle
      4. 8.4. What about Subclasses?
        1. 8.4.1. Figuring out your fixed-income subclass allocation
        2. 8.4.2. Establishing your equity subclass allocation
        3. 8.4.3. Arming your portfolio with the appropriate alternative subclasses
      5. 8.5. An Asset Allocation Case Study
      6. 8.6. Setting Up a Schedule to Revisit Your Plan
  8. III. Building and Maintaining Your Portfolio
    1. 9. Buying Securities
      1. 9.1. Deciding What to Buy
        1. 9.1.1. Individual securities
          1. 9.1.1.1. Stocks
          2. 9.1.1.2. Bonds
          3. 9.1.1.3. Real estate investment trusts
        2. 9.1.2. Funds
          1. 9.1.2.1. Mutual funds versus exchange-traded funds
            1. 9.1.2.1.1. Mutual funds
            2. 9.1.2.1.2. Exchange-traded funds
          2. 9.1.2.2. Index funds versus actively managed funds
            1. 9.1.2.2.1. Index funds
          3. 9.1.2.3. Target and life-cycle funds
        3. 9.1.3. Other investments
          1. 9.1.3.1. Annuities
          2. 9.1.3.2. Options
          3. 9.1.3.3. Structured notes
          4. 9.1.3.4. Exchange-traded notes
      2. 9.2. Figuring Out How to Buy Securities
        1. 9.2.1. Buying through a broker
        2. 9.2.2. Buying on your own
      3. 9.3. Understanding Fees and Expenses
        1. 9.3.1. Mutual-fund fees
          1. 9.3.1.1. Shareholder fees
          2. 9.3.1.2. Annual operating expenses
        2. 9.3.2. Brokerage fees
    2. 10. Knowing Where to Put Your Assets: Asset Location
      1. 10.1. Viewing Your Accounts Holistically
        1. 10.1.1. Considering taxable accounts
        2. 10.1.2. Understanding tax-deferred and tax-free accounts
      2. 10.2. Understanding the Tax Characteristics of Your Investments
        1. 10.2.1. Considering the tax efficiency (or inefficiency) of your investments
        2. 10.2.2. Knowing where to locate investments based on tax characteristics
      3. 10.3. Going through the Asset Location Exercise
    3. 11. Monitoring Your Portfolio: Rebalancing and Other Smart Strategies
      1. 11.1. Rebalancing Your Portfolio
        1. 11.1.1. Dealing with portfolio drift
          1. 11.1.1.1. Defining portfolio drift
          2. 11.1.1.2. Catching the (portfolio) drift
        2. 11.1.2. Rebalancing back to target
        3. 11.1.3. Rebalancing close to target
        4. 11.1.4. Using a working layer of exchange-traded funds
      2. 11.2. Keeping Tabs on Your Securities
        1. 11.2.1. Knowing when to hold 'em and when to fold 'em
        2. 11.2.2. Taking some winnings off the table
        3. 11.2.3. Setting your security guidelines early
      3. 11.3. Making Smart Tax Choices
        1. 11.3.1. Paying attention to taxable gains and losses
        2. 11.3.2. Deferring and offsetting taxable gains
        3. 11.3.3. Harvesting tax loss opportunities with exchange-traded funds
    4. 12. Measuring Your Results
      1. 12.1. Figuring Your Investment Return
        1. 12.1.1. Calculating your return
          1. 12.1.1.1. Paying attention to principal
          2. 12.1.1.2. Coming to terms with term
        2. 12.1.2. Determining the return that's most meaningful to you
        3. 12.1.3. Recognizing that making money isn't necessarily the same as doing well
      2. 12.2. Comparing Your Return to Relevant Benchmarks
        1. 12.2.1. Knowing which indexes to use, and how to use them
          1. 12.2.1.1. Selecting and using a benchmark for comparison
          2. 12.2.1.2. Understanding why benchmark comparisons are useful: Risk and opportunity cost
        2. 12.2.2. Blending benchmark indexes
      3. 12.3. Tracking Your Progress against Your Long-Term Plan
        1. 12.3.1. Determining suitability with a little common sense
        2. 12.3.2. Determining suitability with a Lifetime Cash-flow Projection
  9. IV. Going beyond the Basics
    1. 13. Walking to the Beat of a Different Drum: Opting for Alternative Investments
      1. 13.1. Identifying Investment Alternatives
        1. 13.1.1. Regarding real estate
          1. 13.1.1.1. Residential versus commercial
          2. 13.1.1.2. Real estate investment trusts
        2. 13.1.2. Harboring hard assets
          1. 13.1.2.1. Commodities
          2. 13.1.2.2. Commodity investment vehicles
        3. 13.1.3. Holding hedge funds
          1. 13.1.3.1. Hedge-fund strategies
          2. 13.1.3.2. Funds of funds
          3. 13.1.3.3. Hedge-fund fees
        4. 13.1.4. Exploring more exotic choices
          1. 13.1.4.1. Art and collectibles
          2. 13.1.4.2. Derivatives
          3. 13.1.4.3. Structured notes
          4. 13.1.4.4. Limited partnerships
          5. 13.1.4.5. Private placements
      2. 13.2. Tapping the Power of Investments That Zig when Others Zag
      3. 13.3. Deciding When to Go Alternative
        1. 13.3.1. Hanging on for the alternative investment ride
        2. 13.3.2. Paying enough attention to alternatives
    2. 14. Managing Your Taxes like a Pro
      1. 14.1. Playing It Smart When Selling Securities
        1. 14.1.1. Identifying the information you need
          1. 14.1.1.1. Cost basis
          2. 14.1.1.2. Purchase date
        2. 14.1.2. Figuring the tax implications of your transactions
      2. 14.2. Locating Your Assets Properly
        1. 14.2.1. Understanding tax-advantaged accounts
        2. 14.2.2. Considering an asset location example
      3. 14.3. Harvesting Tax Losses
        1. 14.3.1. Staying alert to tax-loss opportunities
        2. 14.3.2. Using exchange-traded fund swaps to harvest tax losses
        3. 14.3.3. Keeping clean when it comes to wash sales
      4. 14.4. Tax Sensitivity: Good in Small Doses
    3. 15. Knowing When to Revise Your Plan
      1. 15.1. Identifying Life Events That Should Trigger a Review
        1. 15.1.1. Gradual life changes
          1. 15.1.1.1. Aging
          2. 15.1.1.2. Deteriorating health
        2. 15.1.2. Sudden life changes
          1. 15.1.2.1. Birth
          2. 15.1.2.2. Death
          3. 15.1.2.3. Marriage
          4. 15.1.2.4. Divorce
          5. 15.1.2.5. Sudden illness
          6. 15.1.2.6. Job changes, unexpected dilemmas, and windfalls
      2. 15.2. Keeping Your Eye on the Economy
        1. 15.2.1. Recognizing major economic shifts
        2. 15.2.2. Paying attention to the business cycle
      3. 15.3. Considering a Lifetime's Worth of Examples
        1. 15.3.1. Stage 1: Married 30-something parents
        2. 15.3.2. Stage 2: Stay-at-home Jane and a hiccup in the economy
        3. 15.3.3. Stage 3: Failing health and an unexpected windfall
        4. 15.3.4. Stage 4: A grand gesture for the grandchild
    4. 16. Finding Help When You Need It
      1. 16.1. Knowing the Right (and Wrong) Reasons to Hire an Advisor
        1. 16.1.1. The right reasons
          1. 16.1.1.1. To provide objective advice
          2. 16.1.1.2. To avoid amateur mistakes
          3. 16.1.1.3. To help you design and execute your written plan
          4. 16.1.1.4. To put all the pieces together
        2. 16.1.2. The wrong reasons
          1. 16.1.2.1. To "beat the market"
          2. 16.1.2.2. To avoid making the important decisions yourself
      2. 16.2. Weighing Your Options for an Advisor
        1. 16.2.1. Making sense of all those letters after an advisor's name
          1. 16.2.1.1. For help with taxes or financial planning
            1. 16.2.1.1.1. CFP
            2. 16.2.1.1.2. CPA
            3. 16.2.1.1.3. CPA/PFS
          2. 16.2.1.2. For help with investments
            1. 16.2.1.2.1. CFA
            2. 16.2.1.2.2. RIA
            3. 16.2.1.2.3. RR
        2. 16.2.2. Knowing what kind of expertise you need
      3. 16.3. Asking the Right Questions
      4. 16.4. Understanding How Advisors Earn Their Income
        1. 16.4.1. Fee
        2. 16.4.2. Commission
        3. 16.4.3. Fee plus commission
        4. 16.4.4. Performance incentive
  10. V. The Part of Tens
    1. 17. Ten Asset Classes and Subclasses and Their Historical Rates of Return
      1. 17.1. Cash
      2. 17.2. Corporate Bonds
      3. 17.3. Treasury Bonds
      4. 17.4. Municipal Bonds
      5. 17.5. Real Estate
      6. 17.6. Commodities
      7. 17.7. Large-Cap Stocks
      8. 17.8. Mid-Cap Stocks
      9. 17.9. Small-Cap Stocks
      10. 17.10. Emerging-Market Stocks
    2. 18. Ten Common Asset Allocation Mistakes
      1. 18.1. Ignoring Asset Allocation in the First Place
      2. 18.2. Believing That Diversification Is Enough
      3. 18.3. Forgetting to Rebalance
      4. 18.4. Not Having a Long-Term Plan
      5. 18.5. Indulging Your Emotions
      6. 18.6. Paying Too Much Attention to the Financial Media
      7. 18.7. Chasing Performance
      8. 18.8. Thinking You Can Outsmart the Market
      9. 18.9. Ignoring Taxes
      10. 18.10. Disrespecting Inflation
    3. 19. Ten Questions to Test Your Asset Allocation Know-How
      1. 19.1. What's the Best Way to Get Consistently Good Investment Performance?
      2. 19.2. What's Better: An 8 Percent Return or a 9 Percent Return?
      3. 19.3. What's the Riskiest Kind of Portfolio?
      4. 19.4. How Much Variety Should You Include in the Asset Classes You Choose?
      5. 19.5. What's the Best Way to Rebalance?
      6. 19.6. When Should You Rebalance Your Portfolio?
      7. 19.7. When Should You Revisit Your Asset Allocation Plan?
      8. 19.8. Should You Apply Your Asset Allocation Percentages to Each of Your Investment Accounts?
      9. 19.9. How Do You Know How Well Your Investments Have Performed?
      10. 19.10. Where Can You Go for Help with Your Asset Allocation?