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The accountant as investment adviser.

The Accountant as Investment Adviser

Much has been written lately about how to invest at different stages in a person's life. Usually these articles focus on asset allocation at a certain period in life, such as middle-aged couples investing for retirement or retirees investing for income. Pie charts then indicate the percentages that should be invested in stocks, fixed-income securities, money market instruments and inflation hedges. While such information can be useful, it does not address the fundamental issues that lead to a specific asset allocation recommendation. These issues apply at any age and therefore need to be considered first. In other words, there is a common framework that applies at any age and that leads to appropriate asset allocation.

Establishing Investment Goals

Establishing investment goals is the first step in successful investing, yet it often is given little attention. Having definite goals, which are specific in terms of dollar amount and time frame, provides a target to strive for and a means by which to measure progress toward the target. For example, assume a client has a goal of accumulating $200,000 in 25 years for retirement. Through simple time value of money calculations, you can figure various combinations of lump-sum and periodic payments which will achieve that goal, assuming certain rates of return. It is likewise easy to determine if the client is on course in any given year, again through time value of money calculations. If not, adjustments can be made by redeploying assets. Redeployment can take the form of increasing or decreasing funds for that goal or changing the asset mix to get a different rate of return. This approach in achieving goals stands in stark contrast to a vague "I want to make money to provide for retirement" approach. Goals must be carefully thought out, since they have a direct bearing on the types of investments that will be owned.

Considering the Time Frame

The time frame within which the client wants to accomplish his goals is another major factor in determining the investments that will be selected. Investing for a second home takes on a different perspective if that purchase is either one year away or 10 years away. In general, assets with higher short-term volatility, most notably common stocks, provide higher long-term rates of return. Conversely, assets with low short-term volatility, such as Treasury bills, provide lower long-term rates of return. The time frame of the goal, then, can be more important than the age of the investor in determining appropriate investments.

Controlling Risk

Few measures are more important for successful long-term investing than controlling risk. Yet, far too often this is given cursory attention at best. Every investment has some risk, even if it is only purchasing power risk. Indeed, one of the best questions to ask an investment adviser is, "What's the risk in this investment?" He should answer the question directly and intelligently. If he sidesteps the question or, worse, says there is no risk, find another investment adviser.

There are time-tested ways of controlling risk. Some considerations that require attention include the following:

1. Diversification: Diversification needs to include both asset diversification (stocks, bonds, etc.) and securities diversification (several stocks, several bonds, etc.). One type of diversification without the other is insufficient, as people in stock mutual funds found out on October 19, 1987. True diversification protects against large losses to a portfolio caused by being in the wrong security or the wrong type of asset. If a client's resources are insufficient to diversify with different individual financial assets, mutual funds provide a good alternative.

2. Time: The risk of some investment is inversely related to the period those investments are held. This is especially true of common stocks. Over the past 50 years, an absolute loss in the stock market occurred about 30% of the time for one-year holding periods, but virtually never for 10-year holding periods. Thus, the common statement that "stocks are risky" is an oversimplification because it does not relate to the time period during which those stocks are held (nor, of course, to the quality of the stocks being purchased).

3. Leverage: Leverage can be in the form of borrowing money to buy securities, in the form of certain financial instruments such as options or futures contracts, or in the form of an investment that can itself borrow, such as certain mutual funds or limited partnerships. Leverage is a two-edged sword in that it can magnify the return on capital but also the losses. Most people are better off to leave the concept of leverage to professional investors who can follow their positions closely and who can afford the losses that might develop.

4. Risk: Some investments are inherently high-risk. Besides the options and futures already mentioned, other risky investments include penny stocks, oil and gas exploration programs and very low-quality bonds. Although investing in these can be rewarding, in most instances the risk/return relationship is against the individual investor.

The basic premise of controlling risk, then, is to avoid large losses. Small losses will occur to any investor, but they also can be accepted without much disruption of a person's financial situation. Large losses, however, are another matter. They significantly affect a client's plans, goals and financial well-being. It can take years to recover from a large loss -- time some people might not have.

Finally, controlling risk, as mentioned earlier, also includes controlling purchasing power risk. Investors who are too risk-averse can earn a return too low to overcome taxes and inflation. So, while a person can be controlling risk on the surface, being too conservative can gradually lead to a deterioration of purchasing power, just as if losses were realized.

Asset Selection

Conventional wisdom states that young people should invest for growth and older people should invest for income. While these generalizations have some validity, the selection of an asset mix involves more than this, as already has been suggested. The question, then, is which financial assets should be in a portfolio. While there are numerous types of assets that could be included, there are five in particular that deserve consideration:

1. U.S. common stocks; 2. International common stocks; 3. U.S. Treasury notes and bonds; 4. Money market instruments;

and 5. Natural resource common


These assets are suggested because they react differently during given economic environments. More precisely, you can use inflation as your guide to assets that will do well in a certain stage of the economic cycle. During deflation (or at least falling inflation rates), U.S. Treasury securities rise in price as interest rates fall. Furthermore, with a slumping economy, credit risk is not a concern as it would be with corporate fixed-income securities or municipal bonds. (An argument could be made that the tax advantages of municipal bonds outweigh their credit risk. This is probably valid with falling inflation rates but might not be valid during deflation.)

During low to moderate inflation, U.S. common stocks do well. During high inflation, natural resource stocks (oil, gas, minerals, timber and precious metals) provide good returns. Money market instruments track inflation (high or low) while providing liquidity to the portfolio. International stocks, which now account for 67% of total world capitalization, provide the opportunity to participate in growing economies overseas that are fairly independent from the U.S. economy. Thus, an asset mix containing all five categories will have some advantages regardless of the economic picture.

An aggressive investor might ask, "Why not simply buy Treasury securities when inflation falls, stocks during low inflation and natural resource stocks during high inflation?" In theory, this would be fine. In practice, it is virtually impossible to do. History has shown, time and time again, that predicting inflation over any reasonable period cannot be done. This exercise in futility is confirmed by no less than Peter Lynch, the former manager of the Magellan Fund, who admits to not even trying to predict the economy. Time is better spent structuring a portfolio that will provide a reasonable return in any economic environment.

Asset Mix

The proportions of these assets is one of the most difficult issues to resolve because of the many factors already discussed that enter into the solution. It would be nice to have a formula or computer that would produce the ideal mix, but real-world investing is an art, not a science. Normally one would expect to allocate at least 50% to the U.S. and international stock components for younger people, and at least 50% to the Treasury and money market securities components for people close to or in retirement. Rather than provide "recommended" asset distribution that may or may not fit a client's situation, here are two guidelines in determining an appropriate asset mix:

1. Include at least 10% of each

of the five asset classes in the

portfolio. 2. Include not more than 35%

of any one class in the


The basis for these two parameters centers on the inability of anyone to select the best-performing assets with any degree of consistency, as mentioned earlier. Obviously, if a person knew that stocks, for example, would be the best asset for the next 12 months, he would put all of his money in them. With such foresight, it would not take long to become wealthy. It is precisely because no one can predict the best asset on a regular basis that the two guidelines above are needed. Following them prevents an excessive position in any one asset, which normally occurs when that asset is the most popular. It also assures some holdings in assets that might be out of favor and therefore are typically positioned for a rebound. The only two exceptions to these rules would be to permit (1) a larger holding of money market instruments if a short-term goal required a large sum of money and (2) a larger holding of Treasury securities for income-oriented retirees.

Once the portfolio is structured, the main task is to monitor it periodically to see how the asset mix fits the client's current situation. It also enables you to determine whether the client is on track in achieving his goals. Usually, an annual review is sufficient to see the impact of the investments on the portfolio while ignoring the short-term fluctuations in the financial markets and minimizing tax consequences through low turnover.


Life cycle investing should be based on a consistent framework that makes sense regardless of whether a person is 30 or 70. Of course, the specific asset mix will vary from client to client, depending on each one's goals and time frames. Only in a general sense will a person's specific age enter into the allocation process. This framework is not designed to "make a killing," but rather to produce reasonable real returns on a consistent basis with low to moderate risk. Over time, such an approach should prove rewarding for all investors.

Donald W. Johnson, MBA, CFP, is an academic associate at the College for Financial Planning, Denver, Colorado. In this capacity, he coordinates the Wealth Management Series of the College's Advanced Studies Program. A former stockbroker, Johnson has been active in the investments field for more than 20 years. He is the author of Market Timing Techniques With Mutual Funds and Insurance-Based Vehicles as Investments.
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Author:Johnson, Donald W.
Publication:The National Public Accountant
Date:Nov 1, 1990
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