Who: This post is for people looking to either get started in investing, or folks interested in learning about basic portfolio creation.
What: This post is the first in a multi-part series on investing. This specific post will discuss how to create your investment allocation, and also explain what the hell an allocation is.

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This will be the first in a series of posts about investing. As you can see by the title, this series will focus on the basics of investing and help you get started if you are new to this whole investing business. The first step will be to figure out the purpose and nature of the investments you’re making. This is a preliminary step that many investors forego and the results can range from suboptimal performance to absolute disaster.

So, what the hell is an allocation? An allocation is simply a breakdown of the investments that you wish to have in your portfolio, usually by percentage. An allocation shows you what your portfolio consists of. When you are making an allocation for your spending for a week, you figure out what percentage of your money will go to certain things. For example:

Monthly Spending Allocation

Likewise, you break down your investment dollars to see where you are investing each of those dollars. There are many things to take into account when you are making an investment. The major items are described below.

  • Time Horizon -”William, you idiot, who cares when I need this money? I just want to grow it as fast as I can, right now.” This approach to money is shortsighted and often ends up yielding suboptimal results. When creating an investment plan, determine when you need the money is very important. In general, if you will not need the money for awhile, more aggressive approaches can be taken while if your timeframe is short, more conservative investment vehicles are optimal. Perhaps more specifically, short time horizons are appropriate for lower volatility investments while long timeframes are better for higher volatility ventures (Again, this is a suggestion, not a rule). Another reason this is the case is because if you have a longer timeframe, you can ride out volatile periods of slow or negative growth since in theory, the condition will correct itself over time. If you’re investing with a short timeframe, you don’t have this luxury. If you want a slightly more theoretical explanation of why this is the case, read on. Otherwise, skip to the next bullet point.The reason that time horizon should affect your aggressiveness is simple. First, we assume that your investment has a positive expected value (EV). This means that over time, you expect the investment to return money to you and not lose money for you. Unless you’re doing crazy, backwards stuff, we’d want our investments to generally have a positive expected value. Now, with this assumption we know that given an infinite period of time our investment would have an infinite return. More tangibly, the longer we hold the investment the more it will appreciate in value. The next factor that we need to take into account is the volatility of the investment. Bud and Stella play beer pong. Stella is a great beer pong player. She will make 49% of her shots with a very high level of consistency. Bud is also a good beer pong player. He makes 50% of his shots with a much higher volatility. Bud might miss 10 in a row, hit 2, miss 10 more in a row, and then make 18 in a row. He’s a wild card, but his average is better than Stella’s. If we were to play a Beer Pong game, who would we take? Do you get it? If you don’t it is ok. I have drawn all the dots but not yet connected them. If you’re playing a short game, you probably want Stella. But the longer the game is going to be, the better off you are with Bud. The real mathematical nitty gritty is that the extent to which the statements that I just made are true is based on the difference in the shooting percentage and the standard deviation of each of the shooters. I won’t get into all of that here, but basically, if the immediate game is the most important, you want Stella. But the longer your timeframe, the better and better Bud becomes as an option.
  • Goals - Your goals are an important part of your financial planning process. This aspect ties in strongly with your time horizon as well. Are you saving for retirement? Are you saving to purchase a car or put a down payment on a house? Maybe you’re saving for all of the above. Either way, you’ll want to time your investments to fulfill all your goals.For example, if you are saving for a house in 5 years and want to also put a little bit aside for the long term, you might think that you’d like 80% of your investments in short-medium term (less than 5-7 years) investments since you’ll want to take a majority of the cash out in 5 years. The other 20% for retirement can grow in a more aggressive part of your portfolio. What you want to get out of your money is also another aspect of goalsetting that goes beyond simple time horizon assessments. In other words, do you want your money to grow aggressively? Do you want it to grow more slowly but just give you steady income? Your current financial needs should also come into play when you’re looking to make investments.
  • Risk Profile - This is arguably one of the most important aspects of determining what sort of investments you want to make. Your willingness to take risk will determine how aggressive you can be in your portfolio. For an excellent discussion on the risk/reward interplay, check out The Basics III. If you are willing to take risks, for example, you may be interested in equities, small company or international stocks, or perhaps commodities. However, if you’re more moderate, you may be interested in large company stocks, mutual funds, or commercial bonds. Finally, if you want to take the conservative route, you might be interested in treasuries, municipal bonds, or CD’s! As you can see, based on how much risk you are willing to take on, the investment options that are suitable for you vary greatly.
  • Tax Consequences - Some investments are more tax friendly than others. Municipal Bonds and many other government issued securities are exempt from state or federal tax so that individuals who are in a high tax bracket may be best served with some investments in these areas. Short term capital gains (gains in stock price for stocks that you have held for a year or less) are taxed at your marginal tax rate (your tax “bracket”) while long term capital gains and qualified dividends are taxed at 15% if you are in the 25% or higher tax bracket. It is important to recognize the tax consequences of your investments, and as such you should plan your allocations accordingly.

Once you have thought about all of the above points, you’ll be well on your way to getting started in investing. The next post will discuss actually using the information you have thought about to create the allocation that will meet your needs.

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