2004 Lane Reports

It's Time for Your Financial Check-up! Physician, Heal Thyself

Thursday, January 1, 2004
by J. Brad Strom, CFA

It's the start of a new year and an excellent time to reevaluate your financial objectives and strategy. With the Standard and Poors 500 Index up 28.7% in 2003, investors should take a few moments to tally up their holdings in each of the various asset classes and see where they stand relative to their sector targets and overall objectives. With stocks outperforming bonds by such a large margin last year, it's easy to see how portfolio allocations over the course of the year could have drifted outside target ranges.

Revisit Your Financial Objectives and Risk Profile

The first step in an annual review and asset reallocation process should be a review of your financial objectives and risk profile. Have your objectives or your ability to tolerate risk changed over the last year? If the answer is yes, or you've never given it much thought, now would be a good time to consider just what your long-term goals are for your financial assets and how much volatility you are willing to bear to pursue them. The idea is to determine target ranges for each class of assets you intend to use. For most investors that means equities (common stock), fixed income (bonds), and cash equivalents (money markets). This is typically referred to as one's "asset allocation." Larger investors at times add supplemental asset classes to this mix, for example: venture capital, real estate, hedge funds, etc.

A good question to ask yourself when attempting to figure out your financial objectives is:

What do I hope to accomplish with my financial assets?

- Build a nest egg for retirement?
- Leave a financial legacy for my beneficiaries?
- Provide for future lump-sum distributions?
(for college education, home purchase, etc)

The answer to this question is generally fairly obvious. Risk tolerance, on the other hand, is much more difficult to quantify.

When discussing risk (or volatility, as it is typically defined), I like to start by getting clients to consider the time horizon over which their objectives are to be reached. This may or may not be the same as their life expectancy. If the goal is to build assets to leave a legacy for one's beneficiaries, the time horizon should be tied to the beneficiaries' needs; this may allow the portfolio to accept a considerably higher level of risk, even in the portfolios of older investors.

Alternatively, if the objective is a comfortable retirement beginning within the next five years, a much less volatile, more conservative allocation would be recommended.

The innate ability to detach oneself from the often violent gyrations of the stock market and focus on the long-term benefits of this asset class is also an important factor. If you are the type who loses sleep over short-term market movements, an aggressive percentage allocated to common stock holdings probably doesn't make sense regardless of the circumstances. To aid in this area, investment advisors generally ask questions along the lines of:

Rank the following by order of importance (1 = highest)
____ Capital Appreciation
____ Capital Preservation
____ Income Generation
____ Low Volatility (in market value)
____ Liquidity
(Where capital appreciation is ranked it is very informative)

Check the type of investor that describes you best.
____ Aggressive Investor (80%-100% Stock Investments)
____ Growth Oriented Investor (60%-80% Stock Investments)
____ Balanced Investor (40%-60% Stock Investments)
____ Income Oriented Investor (20%-40% Stock Investments)
____ High Income Orientation (0%-20% Stock Investments)

If a $100,000 investment that you made were performing in line with the nation's financial markets and the investment lost value during the first year, at what point would you sell and move to a more stable investment, rather than wait for an increase in investment value?
____ $95,000 (5% decline)
____ $90,000 (10% decline)
____ $85,000 (15% decline)
____ $80,000 (20% decline)
____ Less than $80,000(more than 20%)
____ I would not sell simply due to the decline.
(The higher your tolerance for declines, the higher your risk tolerance)


Determine an Appropriate Asset Allocation

Once you have given consideration to your ultimate financial goals and come to grips with the level of portfolio risk or volatility you are willing to live with, you can then determine or redefine your asset allocation strategy, setting target ranges for each of the asset classes you plan to use.

The following additional considerations might help determine an appropriate asset allocation:

- How long is your time horizon? Is it long enough to realize the long-term benefits and superior returns inherent in equity investments? The longer your time horizon, the greater your ability to accept risk. (If your horizon is less than five years, you probably shouldn't be considering equity investments).

- Do you have any liquidity requirements coming up in the next five years? (If the requirements are short-term, they probably shouldn't be funded with equity investments.)

- Is there any need to generate supplemental income from the portfolio?

- Are there any tax or legal considerations to be taken into consideration?

- Are there any unique circumstances to consider?

Academic studies have shown that when using a "fully diversified" portfolio, 92% of your total return is a function of how your assets are allocated. In other words, if your portfolio is either over- or under-weighted in stocks over a long period of time, it could cost you much more in terms of total return than any other single factor. The lesson here is to take the extra time to develop a sound investment strategy that is appropriate given your individual circumstances such as financial goals, risk tolerance, time horizon, liquidity needs, income requirements, etc.

A typical "balanced" asset allocation strategy might look like the following:

Equity Holdings (Common Stock) 50%-60%
Fixed Income Holdings (Bonds) 40%-50%
Cash Equivalents 0%-10%

Reallocate Your Portfolio Holdings

Strategically reallocating your portfolio holdings periodically - - maintaining target asset class ranges - - will allow you to manage your total risk exposure. For example, let's assume that the "target" allocation of your combined portfolio is 50%-60% in stocks, and you currently hold a 55% position. If, over a period of time (however often you choose to reallocate), stocks rise relative to bonds for the period, bringing their weight in the combined portfolio up above the target maximum of 60% to, let's say 70%, a strategic asset allocation strategy would prompt you to reallocate your portfolio. You would sell stock, buy bonds, and thus bring your weighting in stocks back down to 55% of your total portfolio. You would thus be maintaining your desired risk level and effectively "selling high." The opposite would be true of a weak stock market, where equity positions would be bought to bring the allocation to stocks back up to 55%. By doing this consistently over time, you are able to maximize portfolio return (by definition you wind up "buying low" and "selling high" consistently over time) while effectively managing your portfolio risk.

Having the discipline to adhere to a well thought-out, tax-efficient asset allocation strategy over long periods of time is probably the single most important aspect of a successful investment strategy.

Marc J. Lane Investment Management, Inc. stands ready to assist you in developing - - and implementing - - your optimal asset allocation.

* * *

Our best wishes to you and your family for a Happy and Healthy 2004.


J. Brad Strom is a Senior Vice President and a Portfolio Manager of Marc J. Lane Investment Management, Inc., the registered investment advisory affiliate of The Law Offices of Marc J. Lane, a Professional Corporation. Mr. Strom earned his Master's degree in Finance from DePaul University's Graduate School of Business in 1993 and his Chartered Financial Analyst designation in 1994. He is a member of the Investment Analysts Society of Chicago and the Association for Investment Management and Research. E-mail: [email protected]

Send this page to a friend

The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.

Announcing Marc J. Lane's 35th Book:

The Mission-Driven Venture: Business Solutions to the World's Most Vexing Social Problems

More About The Book
Our monthly newsletter