What the Heck is Asset Allocation?

Basically, asset allocation is how a person "allocates" or divides up their investable assets among different asset classes. It can be as simple as dividing a portfolio in half and putting 50% in a stock index fund and 50% in a bond fund. It can be taken a step further by taking the stock portion and dividing it up among large-caps, mid-caps, and small caps and dividing the bond portion among bonds with different maturies.



Just like having a financial plan, it is important to have an asset allocation plan (also known as an investment plan). Why? Because without an investment plan, people tend to buy what they shouldn't buy when they shouldn't buy it! I know a lot of people who move their 401k money into whatever fund performed best LAST YEAR! The chances of that fund performing best THIS YEAR are pretty slim. But, people do it anyway.



The importance of asset allocation can be best seen with an example. Suppose a person has a written asset allocation plan that says that they will invest in the following manner:



25% or $25,000 - Large-Cap fund

25% or $25,000 - Mid-Cap fund

25% or $25,000 - Small-Cap fund

25% or $25,000 - Bond fund



Let's say in this particular year, the different funds had these rates of return:



Year 1



+10% - Large-Cap fund

+08% - Mid-Cap fund

+15% - Small-Cap fund

-02% - Bond fund



The portfolio would look like this:



(the formula for calculating a return for one year is: Beginning Amount X (1 + the rate of return expressed as a decimal)



$25,000 X 1.10 = $27,500 Large-Cap fund

$25,000 X 1.08 = $27,000 Mid-Cap fund

$25,000 X 1.15 = $28,750 Small-Cap fund

$25,000 X 0.98 = $24,500 Bond fund



Total Portfolio value at end of year 1: $107,750 or a 7.75% rate of return.



Most people would probably want to sell all of their bond fund and put it all in the small-cap fund (since it went up the most!). That's human nature. Nobody likes to hold an investment that seems to be losing money. However, suppose the next year, the fund's returns were like this:



Year 2



- 05% - Large-Cap fund

+03% - Mid-Cap fund

- 20% - Small-Cap fund

+05% - Bond fund



At the end of year 2, the portfolio would like this:



$27,500 X 0.95 = $26,125 Large-Cap fund

$27,000 X 1.03 = $27,810 Mid-Cap fund

$53,250 X 0.80 = $42,600 Small-Cap fund



The portfolio would be worth $96,535 (for a one year LOSS of 10.41%!)



Finally, had this person stuck with their asset allocation plan and reallocated so that 25% was in each of the 4 funds, they would have only had a loss of 4.25% instead of 10.41%:



$26,937 X 0.95 = $25,950 Large-Cap fund

$26,937 X 1.03 = $27,810 Mid-Cap fund

$26,937 X 0.80 = $21,550 Small-Cap fund

$26,937 X 1.05 = $28,284 Bond fund



The portfolio would be worth $103,170 (for a one year loss of 4.25%, which is MUCH better than the 10.41% loss in the above example!).



I must mention one important note: Asset Allocation does not mean that a portfolio will get the best return in any one year, instead it helps smooth out returns.



I hope this helps! Until next time...

Hidden Inflation

Next time you go to the grocery store, go to the frozen food section and look at the ice cream. If you look real hard you might see something different. I'll give you a hint: (the size of the container is smaller). Ice cream companies have started putting their ice cream in 1.75 quart containers instead 1/2 gallon containers, which is really a significant price increase. I call this "sneaky" inflation because most people probably don't even notice.



How much of a price increase is this?



Before, 2 quarts (1/2 gallon) of ice cream sold for $3.98.

Now, 1.75 quarts of ice cream sells for $3.98.



To figure out the price per quart, simply do the following:



$3.98 divided by 2 = $1.99

$3.98 divided by 1.75 = $2.27



To calculate the percentage change in the price, do the following:



FORMULA:



(New Price - Old Price)/Old Price



THE MATH:



($2.27 - $1.99)/$1.99

$.28/$1.99 = .1407 or 14.07%



So, by reducing the container size from 1/2 gallon to 1.75 quarts and keeping the price the same, companies have raised prices over 14%!



Inflation is just a fact of life. But, I respect companies more if they just raise prices instead of being sneaky.



I won't buy the new size of ice cream. I will buy Blue Bell, which is still 1/2 gallon. In fact, they have now started putting "Still 1/2 gallon" on the side of their cartons.



That's my rant for the day. Until next time...

Kids & Money Part III

I took my boys to the library today. I like going to the library. It is nice and quiet there (something I don't get too often since we have 3 kids!).



Anyway, I was browsing through the stacks when I came across a book called Kids, Parents & Money by Willard Stawski. Since I am sort of on a mission when it comes to educating kids about money, I sat down and started reading it. It turns out that Mr. Stawski has a website that accompanies the book (KidsParentsandMoney.com) so I went and checked it out too. I really like his website. I would recommend checking out the links page.



Now go check it out!



Until the next time...

Mission Statements & Financial Planning

It is hard to believe that it has been almost a month since I last posted! Time flies!

The end of 2004 is near, making December a perfect time to reflect on the happenings of this year and begin planning for 2005. I was reviewing my personal mission statement when I started thinking about how a personal mission statement can and should be part of a financial plan. If a personal mission statement is a summary of one's life purpose, shouldn't it be reflected in their financial plan? I think so!

That said, the first step is to develop a personal mission statement. Questions one might ask may include the following:

Why am I here?

What do I want to accomplish in life?

What or who is important to me (also known as "values")?

What are my priorities?

Before I wrote my mission statement I read Stephen Covey's Seven Habits of Highly Effective People. Although I don't agree with everything Mr. Covey writes, I do agree with most of this book. I highly recommend it for everyone to read! In order to effectively write a personal mission statement, one must know what is important to them. What's important to me is:

My relationship with God

My wife

My kids

My job

Charity

Myself

Once a person knows what is important to them, they then need to know what their different roles are in life. My roles are:

Follower of Christ

Husband

Father

Financial Planner

Den Leader

Of course these aren't all the roles I play in life. I listed just those that are most common to me. Once a person knows what's important to them and their roles, they can begin composing their mission statement. Here's my mission statement (altered a bit for privacy purposes):

My mission in life is to first and foremost live for Christ. A man must decide whom he is going to follow. I will follow Christ and seek God's will in all that I do. I will do this by studying the Bible and by praying on a daily basis and by walking in His ways.

Secondly, I will be a loving husband to my wife. I will strive to love her like Christ loved the church. I will practice selfless love, striving to put her needs before my own.

As a father, I will strive to be loving and accepting. I realize that my kids are different, each possessing different talents and abilities given to them by God, and I will strive to treat them accordingly. I will discipline them with love. I will strive to be a good role model for them.

As a financial planner, I will always strive to do what's best for my clients, even it if might not be what's best for me. I will study and keep up on what is happening within the financial planning field. My goal is to develop my firm into a top-notch planning firm with over $50,000,000 in assets by the year 2010! With God's blessing, it can be done.

As a successful financial planner, I will give back to my community. I will teach classes on financial planning and will dedicate myself to worthy causes. I will also strive to be the best Cub Scouts Den Leader that I can be.

Finally, in order to live out this mission, I must be healthy. Therefore, I will eat a proper diet and exercise daily.

I will read this every day!

That's my mission. That's what I'm about. Now, that's not saying that I ALWAYS act in a way that is congruent with my mission. After all, I am human. But, by having my personal mission statement, I can refer back to it daily and it brings me back to where I need to be.

So, what does all this have to do with financial planning? In my next post I'll attempt to explain it.

Until next time...

Getting Organized Part II

I came across a product that I think could be very helpful in getting personal finances in order. The product is called Financial Planning Organizing Kit by a company called HomeFile. I haven't used one yet but am going to order one. I'll post my opinion once I get my HomeFile system.

Getting Organized

Here's an interesting article I found today on the MSN website. This lady has some pretty good pointers on getting personal finances in order.



To that, I might add that it is a good idea to set up an IRA on automatic deposit. This will help a person keep a disciplined investment program.



Good luck!

The Financial Planning Process

What are the steps in the financial planning process? If a person wants to work with a financial planner, what can they expect? What are their responsibilities and the financial planner's responsibilities?



Most Certified Financial Planners* (CFP) use the six step process defined by the CFP Board. Those steps are:



1. Establishing and Defining the Client-Planner Relationship.



This step is usually accomplished with a 30-minute initial consultation. Most planners do not charge for this meeting.



2. Gathering Client Data, Including Goals.



Once the client and planner decide to work together, information is needed from the client. This step can also be conducted during the first meeting.



3. Analyzing and Evaluating the Client's Financial Status.



This step is conducted by the financial planner and can take up to a month to accomplish.



4. Developing and Presenting Financial Planning Recommendations and/or Alternatives.



This step is done in conjunction with step 3. The word "alternatives" means that oftentimes a client's goals are unachievable under current circumstances. Therefore, it is necessary to have an alternative plan of action. This step also requires a client meeting.



5. Implementing the Financial Planning Recommendations.



Once the plan has been accepted by the client, the planner makes out an action items list and both the client and the planner work together during the implementation step. Some clients may prefer to implement on their own.



6. Monitoring the Financial Planning Recommendations.



Notice that these are steps in the Financial Planning Process. A financial plan is a process and not a product. Changes must be made over the years to make sure the plan meets the client's needs. It is recommended that the financial plan be examined at least yearly.



Those are the six steps according to the CFP Board. Not all planners use the six steps, either because they combine various steps or they have additional steps.



I hope my readers found this post helpful. Please send me an email with any questions or comments.



Until next time...



*I am not yet a Certified Financial Planner. I am in the process of preparing to obtain my CFP designation.