Three Simple Steps to Investment Success

8/3/2019 Three Simple Steps to Investment Success

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Three Simple Steps to

Investment Success

Landon Loveall


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Why Does It Matter How I Invest My Money?

Individuals today face far greater challenges with regard to managing their money and preparing for the

future than at any time before. We all recognize this, but it is important to acknowledge the facts as we

discuss the importance of the day-to-day decisions we make regarding our money.

The first challenge individuals face is the change in retirement planning for the individual worker. The

first US private sector pension plan was introduced in 1875 by a railroad freight forwarder, the American

Express Company. Events during the first half of the twentieth century such as the Great Depression

and the end of World War II fueled the growth of the defined benefit pension plan.1 Chances are that

this is the type of retirement plan that your parents or grandparents are benefactors of.

In 1985, the number of single employer pension plans insured by the Pension Benefits Guaranty

Corporation (PBGC) peaked at 112,000. By 2009, the number of plans insured by the PBGC had declined

to 27,650.2

Just as traditional pension plans have decreased since the 1980s, other retirement plans, which placegreater emphasis on contributions from individual participants, have increased. By 2002, both IRA and

Keogh plans (2.3 trillion) and private defined contribution plans (1.9 trillion) exceeded private defined

benefit plans (1.6 trillion), which had led the market at 0.8 trillion dollars in 1985, as a source of

retirement assets.3

The increased independence of the individual is mirrored in areas other than retirement planning.

Among companies offering employer sponsored health care coverage, average worker contributions

increased by 147% from 2000 ($4,819) to 2010 ($9,773). Also, the percentage of covered workers in a

plan with a deductible of at least $1,000 increased from 22% in 2009 to 27% in 2010.4

We Are on Our Own.

The trends in both retirement planning and health care coverage reflect what we have all observed over

the last few years increasingly, we are on our own.

Anya Kamenetz, author ofGeneration Debt, perhaps put this best when she said, Guarantees that over

the past century were provided by employers and the government are being withdrawn. The only way

for us to manage this new raft of risks is to plan better than anyone has ever planned before.5

1Stephen P. McCourt, Defined Benefit and Defined Contribution Plans: A History, Market Overview and

Comparative Analysis, Benefits & Compensation Digest, 43, no. 2 (2006): 1-2, accessed September 28, 2011,

http://www.ifebp.org/PDF/webexclusive/feb06.pdf.2Pension Insurance Data Book 2009 (Pension Benefit Guaranty Corporation, 2010), 25.

3Stephen P. McCourt, Defined Benefit and Defined Contribution Plans: A History, Market Overview and

Comparative Analysis, Benefits & Compensation Digest, 43, no. 2 (2006): 2, accessed September 28, 2011,

http://www.ifebp.org/PDF/webexclusive/feb06.pdf.4Employer Health Benefits 2010 Summary of Findings (The Kaiser Family Foundation and Health Research &

Educational Trust, 2010), 1-2.5

Anya Kamenetz, Generation Debt, (New York: Riverhead Books, 2007), 129.


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Our quest to plan better than anyone has ever planned before is made more difficult by much of the

financial services industry or by what is found in the popular press. Like a ship tossed upon the sea,

individuals are bombarded by advice that is focused on getting rich quickly and on what to buy or sell

now rather than planning for the long-term.

We must first understand what is important in our efforts to build wealth and plan for the future beforewe can begin to take the necessary steps to do so.

What Is Important?

The factors that drive wealth building are not the specific mutual funds you purchase or your ability to

identify the next Google. Wealth building is driven by three factors:

1. How Much You Earn2. How Much You Save3. How Much You Keep

How Much You Earn

How much you earn is a measure of your ability to go out into the world and earn a living. Just as a

business cannot survive without earnings, your ability to earn an income is the first driver to wealth

building. Also, the higher your income is the greater your potential for savings.

How Much You Save

The individual household functions much like a business. Savings is the profit the household produces.

This is a measure of your ability to efficiently manage your household and keep expenses at a level

below income. Our starting point, which we will discuss in more detail later, is to save 10% of annual

income. We also fund our future first by avoiding consumer and credit card debt.

How Much You Keep

The third factor that drives wealth building is how much you keep. How much you keep is determined

by the amount you pay in taxes and expense fees. We manage taxes by utilizing tax deferred savings

opportunities. We avoid paying excess fees by choosing low cost products.

Asset Allocation

Besides the three factors that drive wealth building, the majority of your investment performance will

be determined by asset allocation. A study by Roger G. Ibbotson and Paul D. Kaplan published in the

Financial Analysts Journalfound that 90% of the variability of a funds (mutual fund or pension fund)

return over time could be explained by asset allocation.6 This is where we will focus our attention for

the remainder of this guide.

6Roger G. Ibbotson and Paul D. Kaplan, Does Asset Allocation Policy Explain 40, 90, or 100 Percent of

Performance, Financial Analysts Journal, January/February (2000): 32.


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I referenced earlier the barrage of bad advice and confusion facing individual investors. Asset allocation

is no different. Depending on how you count, Morningstar, a popular investment research website,

breaks mutual funds into more than 20 categories. The overly specific organization of mutual funds by

type, size, region, etc., is unnecessary.

In an effort to help us obtain a sense of clarity, we will consider only two asset categories: interestearning and equities.

Interest Earning

Interest earning assets take the form of cash accounts, CDs, bonds, mortgage equivalents, etc. An easy

way to think about this is, with interest earning assets, you are a loaner. For example, you lend the bank

the use of your funds through cash accounts or CDs. You lend the government or corporation money

through bonds, and you receive interest in return.

Equities

Equities take the form of stock, commodities, closely held businesses, etc. With equities, you are an

owner. Instead of simply loaning your money (interest earning) to the corporation, you receive an

ownership position by purchasing stock. Your expectation through equities is to receive a portion of the

profits through dividends and an increased share value as the business or asset grows.

We could add real estate as a third category, but for now we will focus our attention on the split

between interest earning and equities. We do this because, as the author ofThe Investment Answer

Dan Goldie says, This is the single most important decision you will make.7 We will use a three step

process to help us make that decision.

The Three Step Process

Through the three step process, we adopt a simple and clear process replacing the complex and

confusing decisions about how we invest our money. The three steps are:

Step 1: Look Back We begin by focusing on past behaviors and decisions using the Financial

Life Cycle.

Step 2: Look Around Examining the Five Fundamentals of Fiscal Fitness we focus on current

behavior, and the effect it has on our wealth building progress.

Step 3: Custom TailorWe employ the Ten Risk Factors to make our final asset allocation fit

you as an individual investor.

7Daniel C. Goldie and Gordon S. Murray, The Investment Answer, (New York: Business Plus, 2011), 32.


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Step 1: Look Back

Our current position in life is a product of our past. Nowhere is this truer than with regard to our

money. Our past decisions and behaviors have a direct impact on our current situation.

Still, it can be difficult to gauge where we are relative to where we should be. The Financial Life Cycle is

the tool we use to answer the question, where am I?

You can find a copy of the Financial Life Cycle in appendix 1. Explanation of how to use and interpret it

is given below.

We examine two things using the Financial Life Cycle. The first is your age and the second is your net

worth. The comparison of your age to your net worth allows us to answer the question, Where are

you? That means whether you are on track, behind, or ahead of schedule. Once we determine your

position on the Financial Life Cycle, we can examine the factors that led to this. Those factors will

include your past decisions and things that have simply happened to you along the way.

The Financial Life Cycle includes other information as well. Each stage of the Financial Life Cycle is

marked by a transition point that signals entry into the next stage. Each stage of the Financial Life Cycle

also contains a broad investment strategy. The final piece of information and our focus here is a starting

point for asset allocation.

Consider the example of a couple, both aged 42, who make $150,000 per year. On the basis of their

age, they should be in the Rapid Accumulation stage of the Financial Life Cycle. The determining factor

will be their net worth. Their net worth should be three to seven times their annual income. We would

expect them to have a net worth between $450,000 and $1,050,000. If their net worth falls in that

range, they are on track.

On the next page, you will find a worksheet to determine your position on the Financial Life Cycle. This

will be the first of three worksheets to work through the three step process using your own information.


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The Financial Life Cycle Worksheet

Assets (all assets you own such as house, investment accounts, bank accounts, vehicles, etc)

1. 7.

2. 8.

3. 9.

4. 10.

5. 11.

6. 12.

Liabilities (all debts such as mortgage, student loans, credit cards, auto loans, etc)

1. 7.

2. 8.

3. 9.

4. 10.

5. 11.

6. 12.

Total Assets: _______________ - Total Liabilities: _______________ = Net Worth: _______________

Annual Living Expenses: _______________

Based on my age, I am in the ______________________________ stage of the Financial Life Cycle.

Based on my net worth, I am in the ______________________________.

(If both stages match, you are on track. If your age places you in a stage ahead of your net worth, you

are behind. If your age places you in a stage behind that of your net worth, you are ahead of schedule.)

I am ______________________________.


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Step 2: Look Around

The second step is to look around using the Five Fundamentals of Fiscal Fitness. The Five Fundamentals

serve to measure our current behavior. Are you doing the things now that will build future success? We

look back at the past with the Financial Life Cycle. We look around at the present with the Five

Fundamentals of Fiscal Fitness.

In my work, I sometimes see clients whose past puts them on track in the Financial Life Cycle. Their

present, however, puts them at the risk of falling behind. The Five Fundamentals help us quickly identify

and remedy this.

The Five Fundamentals are:

1. Save 10% of Annual Income: The very first thing we must do to build wealth is to liveconsistently within our means by saving 10% of our income every year. This is our starting point

the foundation of our savings.

Now, for most of us, our first experience with saving money was when we were growing up as

kids. What were we saving for? We were saving for toys, clothes, or that first car. The point is

that we were saving to spend. It is important to note here that Fundamental 1 is permanent

savings. We are saving to invest.

2. Have Sufficient Liquidity: A lot is written in the financial press about saving for emergencies andhaving an emergency fund. The problem is that much of what is written does not account for

the differences in individual employment situations and the different types of emergency

situations.

To satisfy Fundamental 2, we use a dual approach. The first is to have ready cash. Ready cash is

money that you can get access to today, without penalty. It is our basic reserves. The second

part of the dual approach is to have emergency reserves.

It is important to understand what defines a true emergency. A true emergency is not your car

breaking down on the side of the interstate, your home air conditioner burning up in the middle

of the summer, or your television going out on Super Bowl Sunday. No! A true emergency is

anytime your tax bracket drops. This could be due to increased expenses, decreased income, or

both. Examples are a prolonged medical problem, a divorce, or the death of a spouse. This is

what we are preparing for with emergency reserves.

The amount of money we hold in ready cash and emergency reserves is determined by your

employment situation as follows:


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Employment Situation % of Annual Income

Ready Cash Emergency Reserves

Employed 10% 20%

Self Employed 20% 40%

Retired 30% 60%

Unemployed 40% 80%

3. Fully Fund Your Qualified Retirement Plans: Chances are that you are not covered by a definedbenefit pension plan. Fundamental 3 is how we measure your progress toward creating your

own pension through tax-deferred retirement savings such as a 401k, traditional IRA, or SEP.

Remember that one of the things that are most important for building wealth is how much you

keep. Tax-deferred savings gives you the opportunity to save money on taxes today so that you

can save more for the future tomorrow. Our goal is to use 80-100% of the tax-deferral

opportunities available to us.

4. Buy the Right Size House: Among all the assets you own, your house is unique. It providesdiversification by giving you real estate exposure. It provides possible investment return

through increased value. Plus, you get to enjoy it every day by living in it. However, a house

that is beyond what can be reasonably afforded will prove to be more of a burden than a

blessing.

The right sized house is one that is valued at two to two and a half times your annual income.

As your income grows, you should upgrade when the house is valued at one and a half times

your annual income.

5. Eliminate Consumer and Credit Card Debt To build wealth, we fund our future first. We do notborrow from our future to pay for our now. We eliminate and limit the use of all forms of

consumer and credit card debts.

Now that you are familiar with the Five Fundamentals of Fiscal Fitness, look around by rating your

progress toward each Fundamental.


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The Five Fundamentals of Fiscal Fitness Worksheet

Fundamental Target How I Rank

1. Save 10% of Annual

Income

10% of annual income in

permanent savings

2. Have Sufficient Liquidity Determined by employment

situation, see table above

3. Fully Fund Your

Qualified Retirement Plans

Use 80-100% of tax-deferred

savings opportunities available

4. Buy the Right Size

House

A house valued at two to two

and a half times annual income

5. Eliminate Consumer and

Credit Card Debt

Consumer and credit card debt

totals no more than 10% of

annual income.

Ranking:

4-5 Fundamentals Achieved: Congratulations! Your current situation helps to sow the seeds of your

future success.

2-3 Fundamentals Achieved: It is time to jump start your progress and address the problem areas

identified by the Five Fundamentals of Fiscal Fitness.

0-1 Fundamentals Achieved: Look out! If you are not already behind, soon you will be. Change course

immediately!


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Step 3: Custom Tailor

I am sure that right now in your closet or dresser drawer you have that one piece of clothing that fits

better than all the rest. For me, it is my favorite ball cap. For you, it may be hoodie, a pair of stretchy

pants, or that holy t-shirt from college. Whatever it be, it is that one piece of clothing that fits so well

that it is as if the two of you were made for each other. In step three, we want to custom tailor ourasset allocation to fit you.

This is where we bridge the gap from the Financial Life Cycle and Five Fundamentals to you the

individual investor, with a unique story and individual goals. The problem with most asset allocation

models is that they focus only on time and emotional tolerance. Such models suppose that the more

time you have or the younger you are, the more risk you should take. Such models also seek to measure

risk tolerance with simple questions such as, how would you feel if the market dropped 50%?

These asset allocation models leave much to be desired. To make up for where they are lacking, we will

use the Ten Risk Factors to obtain an asset allocation that is authentically yours.

We start with the basic asset allocation obtained from the Financial Life Cycle. We then work through

the Ten Risk Factors and shift our asset allocation based on the results. You can find a blank copy of the

Ten Risk Factors questionnaire in appendix 2. A brief explanation of each risk factor is listed below.

1. Savings as a percentage of income: More than any other factor, how much you save willdetermine your ability to build wealth. A higher level of savings frees us to take more risks in

our asset allocation.

2. Other Risks Taken: The asset allocation of your investment portfolio does not stand alone. It isalso impacted by the risks you take in other areas of life. The more risk you take in other areas

the less you should take with your asset allocation.3. Knowledge of Investments: This factor affects both your emotional tolerance and your ability to

make wise investment choices. The greater your knowledge of investments, the greater your

ability to take risk.

4. Prior Experience with Investments: Prior experience helps you better understand investmentchoices and market cycles. Prior experience increases risk capacity.

5. Inflation Protection: Leveraged real estate is our best inflation protection. We first buy the rightsize house (Fundamental 4). We finance 60-80% of the purchase price of that home with a 30

year fixed rate mortgage to provide inflation protection.

6. Deflation Protection: The interest earning portion of our portfolio provides deflation protection.We build ready cash and emergency reserves (Fundamental 2) into the interest earning part ofour portfolio and invest the remainder in intermediate and long-term interest earning assets.

7. Dependents Spouse: Does your spouse work? The greater the level of dependence by onespouse on the employment of another; the less risk can be taken.

8. Dependents Children: How many children do you have? How many of them are fully dependenton you for support?


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9. Risk Level Needed to Meet Goals: Are you behind on the Financial Life Cycle? You may have totake more risks if you are.

10.Emotional Tolerance: A good, honest assessment of your ability to handle risk is necessary toproperly gauge your emotional tolerance.

Using the worksheet given in appendix 2, you mark each risk factor as low, medium, or high. You thenadd up all the lows, all the mediums, and all the highs. Next, subtract the total lows from the total

highs. Based on that number, go down from either the interest earning tilt or equity tilt to your

Financial Life Cycle stage to find your custom tailored asset allocation.

Quite often the Ten Risk Factors serve to facilitate discussion or promote thought. The actual asset

allocation that is best for you may differ slightly from the one indicated by the Ten Risk Factors. The Ten

Risk Factors will simply help you get there.

Bridging the Divide

Thus far, we have used the three step process to determine our asset allocation for interest earning andequities. We first looked back at our past with the Financial Life Cycle. We then looked around at our

current situation using the Five Fundamentals of Fiscal Fitness. Finally, we custom tailored our approach

using the Ten Risk Factors.

There are still many specific decisions for us to make. What mutual funds should I use? Should I

diversify and how? These questions and others are important for us to answer as well. Before we do, a

slight review is in order.

Available Asset Classes

To this point we have focused only on interest earning and equities because this decision is the mostimportant. It is necessary though for us to get into a more specific description of available asset classes.

Interest Earning: Interest earning assets can be further categorized by type and time frame.o Cash and Cash Equivalents Cash and cash equivalents are short-term interest earning

assets that take the form of bank accounts, money market accounts, or bank CDs with a

maturity of less than 18 months.

o Bonds Bonds are a debt instrument in which the bond issuer owes the bond holder(investor) repayment of principal and interest according to the terms of the bond.

Bonds can be further categorized by time frame

Short Term Bonds or bond mutual funds with a maturity of less than 5 years.

Intermediate Term Bonds or bond mutual funds with a maturity of 5-10 years. Long Term Bonds or bond mutual funds with a maturity of greater than 10

years.

Equities: Equities can be further categorized by the location of the issuing company and size.(Note that although equity assets other than stocks exist we will focus only of stock here.)

o Location


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Domestic Stock issued by companies headquartered in the United States. Developed Markets Stock issued by companies headquartered in countries

other than the United States with developed economies. Examples of non-US

developed economies are Japan, Great Britain, Germany, and Australia.

Emerging Markets Stock issued by companies headquartered in countries withemerging economies. Examples of emerging economies are China, India, Brazil,

and Russia.

o Size Large Cap Companies with a market valuation of greater than 10 billion

dollars.

Mid Cap Companies with a market valuation of 2-10 billion dollars. Small Cap Companies with a market valuation of less than 2 billion dollars.

Now that we have a basic understanding of how to further categorize asset classes beyond interest

earning and equities, we can begin to examine the specific decisions we will need to make.

Principles for Asset Allocation

Life is filled with basic principles such as dont spit into the wind or never buy a watch from a man who is

out of breath. There are principles that can guide our asset allocation decisions as well. These

principles are not written in stone, and the confusion that exists in other areas exists here as well. We

can, however, find a few guiding principles through careful examination.

Risk and Return

The first guiding principle is that risk and return are inseparable. In order for us to accept more risk, we

must in turn receive more return. However, we cannot obtain greater returns without taking on greater

risk as risk and return go hand in hand.

Diversification

Diversification is our way of acknowledging what we do not know, and the one thing no one knows is

what the future holds. We do not know what is going to happen next. What asset class will perform

best this year? What mutual fund will give the greatest returns over the next five years? No one knows!

Consider the Callan Periodic Table of Investment Returns.8 The Callan Periodic Table charts the returns

of nine market indices for the last twenty years. What we find is that todays winner often becomes

tomorrows loser. The chart reveals that during the last twenty years the current years worst

8The Callan Periodic Table of Investment Returns, Callan Associates, accessed October 5, 2011,

http://www.callan.com/research/periodic.


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performing index became the next years best performing index three times (MSCI Emerging Markets in

1998/1999 and again in 2008/2009, Russell 2000 Value in 1999/2000).

We obtain diversification by investing in asset classes with low positive correlation or negative

correlation. Asset classes that have high correlation move in the same direction. When one asset class

moves higher, the other follows suit. Asset classes with high correlation provide no diversification

benefit.

Asset classes with low correlation or negative correlation move in opposite directions. When one asset

class moves higher, the other moves lower. The two asset classes offset each other. The net effect is

that the two asset classes provide the benefits of diversification by offsetting one another and

smoothing market volatility.

It is important to note that the correlation of asset classes is not set in stone. The correlations may

change over time and can even completely reverse themselves. Also, there are times, such as the most

recent financial crisis, when most asset classes will exhibit positive correlation. Such times are the

exception rather than the rule.

Once we have identified asset classes with low positive or negative correlation, we build our portfolio in

such a way that each asset class is big enough to matter but not so big as to be able to wreck us. Each

asset class should be at least 5% of the portfolio but no more than 25% of the portfolio.

Cash is the one exception to this rule. The amount held in cash and short-term interest-earning assets is

determined by the needs of the individual. We first follow Fundamental 2 and build ready cash and

emergency reserves.

Passively Managed

Every year a great deal of investor time, money, and energy are spent (wasted) on trying to beat the

market. It seems so simple. Who did not know that Wal-Mart, Microsoft, or Google were bound for

tremendous success? The results of attempting to beat the market through active management leave

much to be desired.

Passively managed mutual funds do not try to beat the market. They simply purchase a basket of

securities to match the composition of the funds benchmark index. An example of an index that many

index funds track is the S&P 500, which is composed of stock from 500 of the largest US based

companies.

We must first consider the benefits and pitfalls in the decision to choose an active management strategy

or passive management strategy. Consider first the risk and return of active management.


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The first and most prominent risk is that you will pay higher fees. Remember that how much you keep,

which is based on how much you pay in expense fees and taxes, has a huge influence on your ability to

build wealth. Active managers may or may not beat the market, but whether or not they do, they will

always charge you more for trying.

The high fees investors pay for active management create a hurdle that must be overcome every year

for an actively managed fund to simply match the market, much less beat it. The higher fees act like an

anchor tied to the leg of a long distance swimmer. They serve as a drag on returns.

Academic research bears this point out. William F. Sharpe found that the average actively managed

dollar must underperform the average passively managed dollar net of costs, when properly measured.9

In comparing the resources society spends to invest in the US stock market, Kenneth R. French

discovered that for the 1980-2006 period the representative investor would have increased returns by

0.67% using a passive market portfolio.10

Higher fees create the risk of underperformance. This risk is compounded by the inability of active

managers to consistently generate superior returns. The few active managers, who do provide superior

returns, can be difficult to identify leaving investors who try to constantly find themselves in the

unfortunate situation of a dog chasing his tail.

All of this risk is taken for the singular benefit of market beating returns. But, by how much will the

manager be able to beat the market? Will the manager be able to provide market beating returns on a

consistent basis? If the manager begins to underperform, how do I know when it is time to make a

change?

Passive management offers many advantages over active management. Passively managed funds have

lower costs. They simply match a market index and avoid the costs associated with trying to beat the

market. They also avoid high turnover among their individual holdings. Since passively managed funds

match a market index, there is no risk of underperformance.

We have already noted that 90% of return variability over time can be explained by asset allocation. For

this reason and those mentioned in the preceding paragraphs, I recommend a passive management

approach.

9William F. Sharpe, The Arithmetic of Active Management, Financial Analysts Journal 47, no. 1 (1991): 7-9.

10Kenneth R. French, The Cost of Active Investing (April 9, 2008). Available at SSRN:

http://ssrn.com/abstract=1105775


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Regular Rebalance

Most of the confusion in common financial advice involves buying and selling. Some of the confusion,

though, revolves around staying the course. Every time there is a major market drop, you will read and

hear reports that tell you to stay the course. Youre in it for the long term, they say.

Staying the course is important. Even more important is to make sure you are on the right course. The

three step process of looking back, looking around, and custom tailoring will do that for you. Once you

know you are on the right course, you have got to stay there.

Staying on the right course as it relates to your money is much like floating down a river. The river

changes as you float along. Without a paddle, you might end up wrecked on the rocks. Regular

rebalancing of a portfolio is the paddle we use to stay on course.

Over time your portfolio will move away from the initial targets (split between interest earning and

equities) set by the three step process. This occurs because some asset classes will go up while others

go down. Rebalancing is the process of moving a portfolio back to its asset allocation target by buying,

selling, or redirecting contributions.

At a minimum, you should rebalance your portfolio once a year and at the same time every year.

Rebalancing more often can improve portfolio returns slightly. However, it also requires more time on

the part of the investor. The key is to be consistent in your rebalancing.

The three step process starts us on the right course. Rebalancing keeps us there. To maintain progress,

rebalance your portfolio at least once a year.

Putting It Into Practice

At this point, you have all the information you need to achieve investment success and allocate your

assets using the three step process. To provide further aid to you, here is a comprehensive example of

this process in practice.

Jeff and Linda Smith

Jeff and Linda are 42 and 40 respectively. They have two children, Caleb aged 12 and Bethany aged 10.

Jeff owns his own lawn and landscape maintenance company. His business has grown in recent years,

and he earns an income of $150,000 per year from the business. Linda is a nurse practitioner and earns

$90,000 per year. Their combined annual income is $240,000.

They have lived in the same house for the last 10 years. That house is valued at $350,000. They have a

15 year fixed rate mortgage at 6.5%. The mortgage balance is $130,000.


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Jeff and Linda have saved some money. On average, they save 8% of their annual income. They have

some experience with investments and casual knowledge of investment options. They both know they

need to be investing but worry about making the right choices. The up and down movements of the

market sometimes concern them, but they dont lose any sleep at night.

After subtracting total liabilities from total assets, Jeff and Lindas net worth is $600,000. They have an

auto loan on Lindas 2010 Toyota Four Runner with a balance of $21,560. They also have three credit

cards with a total balance of $9,300. Jeff and Linda have $14,000 in ready cash and $2,000 in emergency

reserves.

Step 1: The Financial Life Cycle

See Appendix 1 for a copy of the Financial Life Cycle. Based on their age, Jeff and Linda should be in the

rapid accumulation stage of the Financial Life Cycle. The transition point that marks entry into the rapid

accumulation stage is when investment earnings begin to exceed savings. The true test is their net

worth. At this stage, Jeff and Linda should have a net worth of 3 to 7 times their annual income

($720,000-$1,680,000). Their net worth is $600,000 (2.5 times annual income). Their investment

portfolio (interest earning and equity holdings) is $230,000. So Jeff and Linda are behind.

At the rapid accumulation stage, our investment strategy will be to focus risk and optimize tax

efficiency. We use a base asset allocation of 40% interest earning and 60% equities.

Step 2: The Five Fundamentals of Fiscal Fitness

The Financial Life Cycle told us where Jeff and Linda are relative to where they should be. It is a

reflection of past decisions and behavior. The Five Fundamentals will examine their current situation.

See page 8 for an explanation of the Five Fundamentals.

1. Save 10% of Annual Income: Jeff and Linda are currently saving 8% of their annual income. Thismay be the primary cause of them being slightly behind on the Financial Life Cycle. They should

immediately increase savings to 10% of annual income ($24,000).

2. Have Sufficient Liquidity: Jeff is self-employed, while Linda is employed. Based on this we willuse a hybrid approach for Fundamental 2. We combine the liquidity requirements for employed

and self-employed to reach a recommendation of 15% ready cash and 30% emergency reserves.

Jeff and Linda currently have $14,000 (6%) in ready cash and $2,000 (0.01%) in emergency

reserves. They should adjust current asset allocation and future contributions to first satisfy

Fundamental 2.

3. Fully Fund Your Qualified Retirement Plans: Linda has access to a 401(k) plan through heremployer. Jeff, being self-employed, has the option to choose a number of tax-deferred plans

for his company. Once they are saving 10% of their annual income (Fundamental 1), Jeff and

Linda should take advantage of at least 80% of the tax-deferral opportunities available to them

through qualified retirement plans.


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4. Buy the Right House: The right sized house for Jeff and Linda would be one valued at $480,000(twice annual income) to $600,000 (2.5 times annual income). They should consider upgrading

their house and financing 80% of the purchase price with a 30 year fixed rate mortgage.

5. Eliminate Consumer and Credit Card Debt: Jeff and Linda should work to pay off their auto loanand credit card debt in the next three years. From that point forward, Fundamentals 1 and 2

will help to prevent further use of consumer and credit card debt.

Step 3 The Ten Risk Factors

See Appendix 2 for a copy of the Ten Risk Factors and page 11 for the Ten Risk Factors explained.

Risk Factor Rating Reason

1. Savings as a percentage of income Low (


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changed it since. Also, Jeff and Linda have not rebalanced on a regular basis. Their current allocation is

a product of the work they originally did in their 30s, the allocation of their contributions, and the

movements of the market.

The Financial Life Cycle established a base allocation of 40% interest earning and 60% equities. We

refined this base allocation using the Ten Risk Factors to a target asset allocation of 50% interest earning

and 50% equities.

The following is an example of what Jeff and Lindas portfolio might look like.

Percent Asset Class Index

16% Cash N/A

24% Bond: Short Term Barclays Capital 1-5Y Government/Credit Bond Index

5% Bond: Intermediate Term Barclays Capital 5-10Y Government/Credit Bond Index

5% Bond: Long Term Barclays Capital US Long Government/Credit Bond Index

15% Domestic: Large Cap S&P 500 Index10% Domestic: Mid Cap MSCI US Mid Cap 450 Index

10% Domestic: Small Cap MSCI US Small Cap 1750 Index

10% Developed Markets MSCI EAFE Index

5% Emerging Markets MSCI Emerging Markets Index

It is important to note that the cash and bond: short term allocation is driven by Fundamental 2. 16% of

their portfolio in ready cash would be $36,800. 24% of their portfolio in emergency reserves (bond:

short term) would be $55,200. This puts them just short of their emergency reserves target, which is

30% of annual income or $72,000. Future contributions to the interest earning side of their portfolio

should be first directed to bond: short term until they have satisfied their requirement for emergency

reserves.

At this point, we have followed our principles for asset allocation. No individual asset class makes up

more than 25% of Jeff and Lindas portfolio, and all asset classes make up more than 5% of their

portfolio. Their expected return (see appendix 3) from a portfolio such as this is 8.2%. The last thing Jeff

and Linda must do is select low-cost, passively-managed mutual funds that track the proper index and

invest their assets accordingly.

Conclusion

The amount of responsibility we have as individuals to plan for our future is growing. At the same time,

the complexity of the decisions we must make grows as well.

By following the three step process and principles for asset allocation, you can first look back and

examine where you are using the Financial Life Cycle. Through the Five Fundamentals of Fiscal Fitness

you can examine your current situation and establish the habits that will fuel your future success. The


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Ten Risk Factors and principles for asset allocation will help you custom tailor your approach and stay on

the right course.

All that is left is for you to act. Do so immediately. Neglecting to act is as great a mistake as having an

improper asset allocation to start with. Do not delay. Your future depends on you.


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Appendix 1 The Financial Life Cycle

StageBuilding the

Foundation

Early

Accumulation

Rapid

Accumulation

Financial

Independence

Conservation Distribution Sunset

Transition

Poin

t

Becomes self-

supporting

Net worth more

than annual

income

Investment

earnings exceed

savings

Investment

earnings equal

50% or more of

living costs

Live off

investment

earnings

Have more money

than can be spent

in lifetime

Less than 12

months to live

Net

Worth

Less than annual

income

1-3x annual

income

3-7x annual

income

7-10x annual living

expenses

10-15x annual

living expenses

More than 15x

annual living

expenses

Strategy

Five Fundamentals

of Fiscal Fitness

Diversify into

stocks and bonds

Focus risk and

optimize tax

efficiency

Supplement

earnings with

investment

income

Consolidate lower

risk investments

Start giving money

away kids,

charities, etc.

Distribute assets,

reduce estate

taxes

AssetAllocation

75% Interest

Earning, 25%

Equities

50% Interest

Earning, 50%

Equities

40% Interest

Earning, 60%

Equities

50% Interest

Earning, 50%

Equities

60% Interest

Earning, 40%

Equities

75% Interest

Earning, 25%

Equities

Age 20 - 29 30 - 39 40 - 54 55 - 69 70 - 85 85 +

1996-2004 Bert Whitehead, MBA, JD/Cambridge Advisors


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Appendix 2: The Ten Risk Factors

Client: ________________________________________

Risk Factor Low Medium High

1. Savings as a percentage of income 12%2. Other risks taken (job, business, etc.) Many Some Few

3. Knowledge of investments Not very Moderate Very

4. Prior experience with investments Not Very Moderate Very

5. Inflation protection (leveraged R/E) Fair Good Great

6. Deflation protection (treasuries) Fair Good Great

7. Dependents: Spouse Full Support Partial Support N/A

8. Dependents: Children Full Support Partial Support N/A

9. Risk level needed to meet goals Low Medium High

10. Emotional tolerance Low Medium High

TOTALS

Total Highs minus Total Lows = __________

Interest Earning Tilt Default Equity Tilt

Stage -8 -10 -5 -7 -2 -4 -1,0,+1 +2 +4 +5 +7 +8 +10

Building the Foundation 90/ 85/ 80/ 75/25 /30 /35 /40

Early Accumulation 65/ 60/ 55/ 50/50 /55 /60 /65

Rapid Accumulation 55/ 50/ 45/ 40/60 /65 /70 /75

Financial Independence 65/ 60/ 55/ 50/50 /55 /60 /65

Conservation 75/ 70/ 65/ 60/40 /45 /50 /55Distribution 90/ 85/ 80/ 75/25 /30 /35 /40

2004-2008 Alliance of Cambridge Advisors, Inc. All Rights Reserved


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Appendix 3: Expected Returns

Asset Allocation Compound

Annual

Return

(Since

1926)

Worst Returns (Last 50 Years Recent Down Markets

StocksInterest

Earning1 year 3 years 5 years

10

years

10 year

(annualized)

1973-

74

2000-

022008

10 90 5.4% -1.2% 5.8% 15.5% 24.6% 3.7% 7.2% 17.4% 2.8%

15 85 5.8% -0.1% 9.6% 21.1% 52.1% 4.3% 4.4% 14.3% 0.6%

20 80 6.2% -1.7% 9.2% 20.4% 52.4% 4.3% 1.6% 11.2% -1.7%

25 75 6.5% -4.0% 7.0% 19.2% 51.2% 4.2% -1.2% 8.1% -4.0%

30 70 6.9% -6.3% 4.8% 18.0% 49.8% 4.1% -3.9% 5.1% -6.3%

35 65 7.3% -8.6% 2.2% 16.6% 48.2% 4.0% -6.6% 2.2% -8.6%

40 60 7.6% -10.8% -0.7% 15.2% 46.4% 3.9% -9.2% -0.7% -10.8%

45 55 7.9% -13.1% -3.5% 13.7% 44.0% 3.7% -11.8% -3.5% -13.1%

50 50 8.2% -15.4% -6.3% 12.0% 41.4% 3.5% -14.4% -6.3% -15.4%

55 45 8.6% -17.7% -9.1% 9.2% 38.7% 3.3% -16.9% -9.1% -17.7%

60 40 8.8% -20.0% -11.8% 6.4% 35.8% 3.1% -19.4% -11.8% -20.0%

65 35 9.1% -22.3% -14.4% 3.6% 32.8% 2.9% -21.9% -14.4% -22.3%70 30 9.4% -24.5% -17.0% 0.8% 29.7% 2.6% -24.3% -17.0% -24.5%

75 25 9.7% -26.8% -19.5% -2.0% 26.4% 2.4% -26.7% -19.5% -26.8%

80 20 9.9% -29.1% -22.0% -4.8% 23.0% 2.1% -29.0% -22.0% -29.1%

85 15 10.1% -31.4% -24.4% -7.6% 19.4% 1.8% -31.4% -24.4% -31.4%

90 10 10.3% -33.7% -26.8% -10.3% 15.8% 1.5% -33.6% -26.8% -33.7%

Note: The statistics above reflect a stock allocation of 75% domestic: large cap and 25% domestic: small cap prior

to 1966. After 1965, the stock allocation is 60% domestic: large cap, 20% domestic: small cap, and 20%

international. The bond allocation is 50% short-term and 50% intermediate-term.


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