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Ways to Invest Safely in a Jittery Market

The author of 'The Safe Investor' shows how to take the Three Pockets approach

By Tim McCarthy | February 18, 2014
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Tim McCarthy is author of The Safe Investor. He was CEO and Chairman of Nikko Asset Management, President and COO of Charles Schwab & Co. and President of the Fidelity Investment Advisor Group.

The recent dramatic plunges in the U.S. stock market, after a year when the Dow rose 27 percent, show just how impossible it is to time the market short-term. The same is true for investing in markets of other countries, too.

This is why, about 12 years ago, I developed a process and a tool for investors to help them understand what a proper investment approach looked like and to use it as a guide to fulfill their long-term goals. I call it "Three Pockets."

The “Three Pocket” Approach
 
The pockets are the "Savings Pocket," the "Investing Pocket" and the "Trading Pocket."
 
The Savings Pocket is the money you can't afford to lose and that you can get to in an emergency.
 
The Investing Pocket is the money that lets you stay broadly diversified; it should generally be left alone for a long time.
 
The Trading Pocket is the money that you can afford to risk and could grow your portfolio dramatically. You should set aside new money each year in your Investing Pocket before you fund a Trading Pocket.
 
(MORE: The ‘Safety First’ Guide to Retirement Withdrawals)

Here are my general guidelines for allocating money in your three pockets up to your mid-50s and if you’re between your mid-50s and your early 70s:
 
Investing Up to Your Mid-50s
 

In this age bracket, you’re likely still paying a mortgage, have kids in college and maybe even have to pay for your own parents’ health care. It is hard to think about your own long-term investing needs or have the ability to save up enough for an Investing Pocket. But the earlier you can start, the more robust your financial plan will be.

Savings Pocket: The first thing you have to do is build up an emergency fund. Depending on your family size, the age of your children, and job security, ideally you would like an amount equal to six to nine months of expenses with an absolute minimum of three months. When your future income is highly uncertain, you might want a year’s expenses in this pocket.

At this age, you can have some slightly higher-yielding, short-term funds in this pocket.

(MORE: 7 Secrets of Highly Effective Retirement Savers)

Try to have at least some money in a second institution, either another bank or broker, to avoid the possibility of losing all or a major portion of your money — the risk of a Single Point of Failure (or SPOF). One bank can hold your savings account while a brokerage account can contain your money-market fund.

Investing Pocket: At a minimum, make sure to take advantage of tax-sheltered IRAs and 401(k)s every year. We don’t get many opportunities in our lives for such gifts, so don’t miss out on them.

Then, after funding these, if you have even a little bit of additional money to add to your Investing Pocket, even a few thousand dollars, you are ready to talk to someone about your investing options.

If you don’t have enough money to interest a financial adviser, I recommend either using a reputable internet broker or a broker or bank with access to investment pros you can ask questions of, even if that’s on the phone. I recommend finding a rep in the firm with at least ten years’ experience; you really want someone who has lived through a couple of investment cycles, so you know they’ve seen what can go wrong.

This is also the time to invest in more aggressive growth stock funds — such as funds investing in small-company stocks and emerging countries as well as high-yield and moderate-rated corporate bond funds. At this age, you can take advantage of volatile asset classes that, over the long run, yield considerably higher returns.

Recommended Asset Allocation: U.S. and international equities: 60 to 90 percent; U.S. and international fixed income: 12 to 30 percent; Real estate and commodities: 10 to 20 percent

Trading Pocket: As a very rough rule of thumb, at this age, you should always have far less money in your Trading Pocket than in your Investing Pocket. Remember, as you get into your 50s, you might not be able to make back the money.


Investing In Your Mid-50s to Early-70s

Your retirement age is now within sight. It is critical that you now begin putting away a larger amount of money into your Investing Pocket.

If you have a 401(k) plan or a pension plan, a family trust or an annuity, it is very important to know which underlying asset classes you are exposed to in them. That way, you can incorporate this information to ensure that your asset allocation mix is sensible. You don’t want to inadvertently double up your bet in one asset class.

(MORE: A New Approach to Owning Stocks in Retirement)
 
I often see people in this age group owning a long-term, guaranteed fixed-return product that’s closely correlated with the risks and returns of a long-term bond fund. Yet, they may also own a larger portion of their own managed portfolio in bonds as well. Thus, they end up with double the exposure to bonds and not enough exposure to equities.

If you have a considerable estate — over $5 million in financial assets plus a lot of real estate with little or no mortgage — you may want to hire a trust attorney to review your life financial plan. If something happened to you and your spouse, the IRS can take a big a portion of your estate.

Savings Pocket: Normally, this pocket should remain at a steady level, because additional funds should go into the Investing Pocket to get you the growth you need. However, it is certainly ok to have the equivalent of a full year’s worth of expenses in this pocket.

If you have any extra money beyond what you’re putting into your Investing Pocket, accelerate the payoff of your mortgage. By the time you retire, it is prudent to have virtually no debt.

You may have saved up to a point where you are reaching the upper limits of FDIC insurance in any one of your bank accounts ($250,000 per depositor). If so, open up a few accounts at multiple banks to avoid an SPOF.

Investing Pocket: Until you retire, this pocket should remain in full growth mode because you and/or your spouse are likely to have 30 or more years after you stop working for your money to last. Even after you retire, keep any adjustments to your portfolio to a minimum.

In the decade after you retire, you (and your advisor, if you have one) should begin to:
  • Move gradually out of speculative emerging-markets countries and focus more on growth and developed countries
  • Slowly decrease your exposure to the more speculative high-yield fixed income funds and increase holdings in rated debt instruments

By the end of your 60s, it may also be wise to adjust your equities portfolio so you’ll have less exposure to growth stocks and small company stocks. Replace those types of funds with ones that have more dividend yield.

Recommended Asset Allocation: U.S. and international equities: 45 to 65 percent; U.S. and International fixed income: 20 to 40 percent; Real estate and commodities: 8 to 15 percent
 
Trading Pocket: By the time you retire, you’ll want to have your Investing Pocket fully funded. If you have excess money left over, even after allowing for potential, and expensive, health care and assisted living costs, have some fun if you want to enjoy the game of trading stocks. Though the odds of winning are not great, they’re better than Las Vegas.

A note of caution: I have seen many instances where a little extra money resulted in people losing way too much money. Sometimes, a speculative investment can pull you into further obligations that end up digging deeply into your Investing Pocket.

So be careful here. Don’t make the mistake of throwing good money after bad. Better to accept your losses and move on than think you have to put more money into an investment to save it.

 
This article is adapted from The Safe Investor: How to Make Your Money Grow in a Volatile Global Economy by Tim McCarthy. Copyright © 2014 by the author and reprinted by permission of Palgrave MacMillan, a division of Macmillan Publishers Ltd.
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