Tuesday, December 7, 2010

Asset Allocation methods from the masters Part 1: Peter Lynch

I recently watched an episode of the Suze Orman show where someone with about $2 million in net worth asked Suze if she could afford to retire soon, and Suze actually gave that person a pretty low grade (it was a C- I think). The problem was that lady had a significant portion of her assets in undeveloped land that doesn’t generate any income for her.

Side note: I’m recalling what I saw on the Suze Orman show strictly from memory, and my account of what happened might not be 100% accurate. But you get the point I’m trying to make.

After watching that episode, I really started to appreciate how much asset allocation mattered. Sure, saving money is good. But knowing where to invest your money or how to allocate your assets is crucial to building significant wealth.

In part 1 of this 3 part series, I will be looking into the asset allocation method suggested by Peter Lynch. I will be talking about the asset allocation method suggested by Benjamin Graham in part 2 of this series, and in part 3, I will be talking about an asset allocation method inspired by Warren Buffett.

Here’s the asset allocation method suggested by Peter Lynch:

In his book “Beating the Street,” Peter Lynch talked about how stocks will outperform bonds over time, and that if an investor wants to increase the value of his or her portfolio, that investor better have part of his or her portfolio invested in stocks.

Peter Lynch suggested that investors increase the stock component of their portfolios to as much as they can tolerate, as unlike bonds, stocks can appreciate in value and increase the dividends they payout to investors. He even included data in his book showing the results of $10,000 invested for 20 years in all bonds, split 50/50 between bonds and stocks, and 100% in stocks (In the 3 scenarios, it was assumed that bonds paid 7% interest and stocks had a dividend yield of 3% and appreciated at 8% a year. True stocks might not return that much anymore, but I believe stocks will still easily outperform bonds over the long-term, especially if companies like IBM can borrow money at 1% interest).

A 100% bonds portfolio would return $14,000 in interest income and the original principal of $10,000.

A 50/50 split between bonds and stocks would return $10,422 in interest income, $6,864 in dividends and a portfolio worth $21,911.

100% invested in stocks would result in $13,729 in dividends and a portfolio worth $46,610.

Another scenario in the book showed that even if you need income, stocks still make for a much better investment than bonds (The scenario assumes a 3% dividend yield and an annual 8% in capital gains). Here’s the scenario:

If an investor had $100,000 to invest and needs $7, 000 in income, the investor can just put all of the $100,000 in stocks, even if stocks only have a 3% dividend yield. This is the case as the investor can just sell some shares to supplement his or her income until the dividends reach his or her income target ($7,000 in this case).

So, the investor would get $3,000 in dividend income at the end of the first year, and have to sell $4,000 worth of stock to get $7,000 in income. But if the investor’s stocks appreciated at 8%, he or she would have a portfolio worth $104,000 after selling the $4,000 worth of stock.

At the end of the second year, the investor’s dividend income would have increased to $3,120. This would result in the investor only having to sell $3,880 worth of stocks. The investor’s portfolio should, according to my calculation, be worth $108,440.

Every year, the investor’s dividend income rises, and he or she will need to sell less stock (eventually not needing to sell stock at all). The investor’s original investment would also have grown every year. At the end of 20 years, the $100,000 would have turned into $349,140, and the investor would have had income of $146,820. A 100% bonds portfolio that pays a 7% interest would only return $140,000 in interest income and the original principal of $100,000.

Peter Lynch pointed out that even if investors know that stocks are much better than bonds, stocks don’t appreciate in a straight line, and not all investors can keep their emotions stable and ride out the corrections of the market or sometimes even sell some of their shares at depressed prices to supplement their income. That’s why I think he recommends investors to hold in their portfolios as much stock as they can tolerate instead of have a 100% stock portfolio.

I personally am almost fully invested in stocks, as I believe that businesses will continue to be the greatest creators of wealth, and investing in stocks is one way to get invested in businesses. The other way is, obviously, through setting up your own private companies, but that might not be for everyone (I have plans to set up a holding company sometime in the next few years, but until then, stocks will probably be the only asset class I’ll invest in).

In my next article for this 3 part series, I will be talking about an asset allocation method suggested by Benjamin Graham. So, check back soon if you’re interested.

Before I go, please allow me to be true to my “captain obvious” nature and list down some “very obvious” points related to this asset allocation series. Here are the “very obvious” points:

We should all have a 6-8 month emergency fund in case something unexpected happens and we need cash (this emergency fund should not be thought of as part of your investment portfolio, and should generally be established before you start investing).

It’s ok if you don’t understand how to value stocks or companies. You still can get exposure to stocks by investing in a low-cost index fund or a good mutual fund.

Sometimes stocks can be drastically overvalued, and it might not be such a good idea to buy stocks for your portfolio during those times. It might, however, be a good idea to build up cash when you can’t find attractive opportunities, so that you have some cash to put to work when you do find investment opportunities that you believe are attractive.

You should only invest money that you won’t need for a very long time to come.

You don’t need to follow the asset allocation method in this article or the asset allocation methods I plan to talk about in the future articles of this “asset allocation” series of articles. Just make sure that you understand what you’re investing in (whether it’s stocks, real estate, commodities, or etc).

Common sense and rational thinking should always prevail.

If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

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