When investing in a portfolio, there only a handful of things that you can control that will influence returns. They are:
- Asset allocation (stocks versus bonds)
- Security selection (which stocks or bonds)
- Market timing (buy now or later)
Significant research has been done on these factors. By and large, security selection and market timing are not likely to result in outperformance.
As security selection and market timing are most often undertaken by active managers of mutual funds, it is interesting to read reports showing that over long periods of time, over 90% of active managers underperform their relevant index.Even the pros can't pick and choose the investments and timing to beat the market. This is actually good news because it means the easiest way to invest is also the best.
Passive Investing–Why It Rocks
Low costs save you money, meaning your earnings go farther. A fund that costs 2% a year will have to have 2% greater returns than it's index just to match it.
Let's say I invest $1,000 with an investment advisor who charges a 2% fee. His job is to outperform the S&P 500 index for me. Meanwhile, you invest $1,000 in a low-cost mutual fund that is set to track the S&P500. This fund charges .05%
After one year the S&P 500 grew by 10%. According to studies, 90% of active managers do worse than the index, but my guy is awesome and actually got me 11%! This is the cream of the crop of investment advisors. So I have $1,110. But I have to pay fees of 2%, which brings my balance down to $1087.80. I'm pretty happy. I made $88!
However, your low-cost mutual fund matched the S&P500 index perfectly so it grew 10%. Your balance is now $1,100 minus the fee of .05%. This brings your balance down to $1099.45.
You won. You made more money even though you technically had worse returns.
And that's a best-case scenario. The vast majority of advisors don't even match the market, let alone beat it. A truer story is that my guy earned 9% and I still had to pay him his 2% fee.
How To Determine The Appropriate Allocation
The fact remains that most investors are nervous about making decisions and would rather pay someone to do it for them. But I promise you can do this on your own. It's not hard once you know a few key things.
For simplicity’s sake, let’s just consider a stock and bond portfolio. Choosing the ratio of stocks to bonds will have the largest impact on your portfolio’s expected return and how volatile your ride will be.
Historically, stocks have historically outperformed bonds. Therefore, the more stocks you own, the higher the expected return will be. However, with higher highs come potentially lower lows. It is of paramount importance to figure out the correct allocation since taking too much risk could cause you to abandon your strategy when the volatility hits.
Investing conservatively allows you to keep more of what you earn on the upside while minimizing the downside. You'll want to take enough risk to get you to where you need to go, but you don't want to take more risk than necessary.
Properly determining your appropriate allocation involves a few steps. I like to view this as a three-legged stool, with each step providing support to the final recommendation. The three legs are risk capacity, risk tolerance, and risk perception.
Risk capacity can be summed up as how much risk you must take to meet your goals and how much risk you can afford to take.
If your goal is to reach financial independence in a specific time frame, we can solve for the rate of return needed to reach that goal. Then, based on historical rates of return, we can back into an allocation to achieve that rate of return.
What if you are trying to get to Financial Independence as soon as possible? This is a little more open-ended and we would probably look at a range of returns and project how long you would need to work to meet your goals. Because higher stock allocations have historically provided higher rates of return, the time frame to FI will be shorter with a higher allocation to stocks. Sometimes, we have to determine whether the goals are realistic. Once this is sorted out, we’d have one half of one leg of our stool.
The other half of risk capacity is the amount of risk you can afford to take.
If you are planning on purchasing a house, then a large portion of your savings may be used for the down payment. Another example would be as you approach retirement. In retirement, you will need a set amount of cash to live on. You cannot afford to take any risk with that pot of money. Therefore, your overall ability to take risk is lower. Based on experience, I think it is best to plan for having eight years of cash needs in low-risk investments such as cash and bonds.
This is another component of the financial planning process: projecting out cash needs and determining how they impact your portfolio allocation. If you are planning on using the 4% rule of thumb to guide your portfolio withdrawals, this corresponds to a roughly 65-70% stock allocation.
Risk tolerance is how much risk you can handle emotionally. There are a number of tests, quizzes, and software out there that can provide insight on your risk tolerance. They aim to determine when you would abandon your strategy and move to cash.
Would you be able to withstand a 40% drop in your portfolio? It may be easy to say yes now, but what if your $1,200,000 portfolio dropped to $720,000? Would you pull your $720,000?
Investors usually view portfolio increases in percentage terms, but portfolio losses in dollar terms. Dollar losses just seem to hurt that much more.
The simplest way to determine your risk tolerance would be to ask yourself how much money you could stand to lose, in dollar terms. Then, translate that to a percentage decline. Historically, bear markets have an average decline of 32%. If you could tolerate a 16% decline in your portfolio balance, an allocation of 50% to stocks would be in the right ballpark. This assumes that bonds do nothing in the bear market–usually, bonds have positive performance as there is a “flight to safety” during a stock market decline.
Risk perception is the squishiest of the elements of determining your proper allocation. If you think that stocks are never going to go down in value, your perception of risk is low and therefore you are willing to invest more in stocks. Of course, we know that our perception of risk is usually wrong and can change rapidly.
Consider this example: Let’s bet on a flip of a coin; if it lands on heads I’ll give you $2, and tails you get zero. How much would you pay to play that game? Statistically speaking, a $1 bet would be appropriate, but what return did you require to compensate you for the risk? A wager of 50 cents means you require a 100% return to play the game. Likewise, 80 cents indicates a 25% rate of return requirement, and 90 cents equates to an 11% rate of return.
How many times in a row will it need to land on tails before you lower your bet? Did the risk of loss really change or did your perception of risk change?
Usually, investors with more experience have a lower perception of risk. In my experience, those with longer time horizons also have a lower perception of risk. This is because they have ridden the ups and downs of the market, and over time the markets bounce back. However, this perception is highly individualistic and your circumstances will impact your risk perception.
Implementation Of Your Proper Allocation
Risk capacity and risk tolerance do not change much over the course of your life. Therefore, you should give these items a higher weight than risk perception in determining your allocation.
Because risk perception is dependent on many variables, often the most recent news story you saw, you should be wary of changing your investments based on your current perception of risk. Use an investment policy statement or investing rules to make sure you don’t adjust your allocation in a knee-jerk manner when you perceive the market is riskier.
With that said, it may make sense to ease into your allocation by dollar cost averaging into stocks if you perceive the risk to be high. Using a three or six-month time frame to get to your allocation, will lower the emotional risk involved with investing a lump sum. While you may sacrifice returns on average, the emotional relief is likely worth the cost.
Conversely, with bonds, there is less risk of a significant pullback in bond prices, so dollar cost averaging doesn’t provide as much value. Therefore, a good plan to invest a 60% stock and 40% bond portfolio would be to do 10% stocks and 40% bonds in the first month, keeping 50% of the portfolio in cash. Over the next five months, investing 10% per month into stocks would get you fully invested in six months with lower emotional risk.
If you have been reading closely, you’ve probably seen a lot of “ballpark,” “roughly” and “approximately” comments. Getting your allocation correct is definitely more art than science since emotions run high with investing. Getting the correct investment mix can involve some trial and error.
I would not recommend a “set it and forget it” approach, especially when your risk perception changes. If you suddenly feel that your investments aren’t allocated appropriately, my final recommendation would be to try to calm your nerves by reviewing the risk capacity and risk tolerance exercises and see if a change in circumstances might warrant a change in your allocation.
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