When you think of investing, you might believe you have no control over the outcome. Perhaps you think of a casino, where the "house" always wins in the end, while hapless gamblers continue stuffing hard-earned dollars into the slots, fervently hoping for a big payout.
Fortunately, there is good news for people investing for their retirement.
It's true that nobody can control the movements of the stock-and-bond markets. There's a positive aspect to that: It's exactly because of this uncertainty that investors are rewarded for taking the risk.
But retirement planning is more complex than simply taking a flyer on the market, or, even worse, stashing your funds in a certificate of deposit or money market account, the modern-day equivalents of the coffee can in the backyard.
This is where financial advisors add value for clients. Despite market vicissitudes, there are several areas of your financial and investing life that you can control to give yourself a greater chance of a successful retirement outcome.
Here are three points to remember:
-- Develop an investment plan tailored to your needs and risk tolerance.
-- Structure your portfolio around dimensions of returns.
-- Diversify broadly.
Plan Based On Your Needs and Risk Tolerance
Investing isn't about just growing a bigger pot of money than the next guy. That's an old-school stock broker's approach, put into practice before the science of investing and financial planning came into its own.
Jeff Mills, co-chief investment strategist at PNC Financial Services Group in Philadelphia, says investors must consider risk, but their goals should come first. "If you build an investment portfolio that only takes into account how much risk you can tolerate, you are then simply left with the result of that asset allocation, with no consideration of what you need that portfolio to accomplish in the long run from a returns perspective."
Mills emphasizes that investing should help achieve a specific goal, such as retirement. "You should always start with the goal first: What do I need my investment to produce in order to meet my financial goals? From that point, you can work backwards and see how much risk you likely need to take to accomplish that goal," he says.
Sara Behr, owner of Simplify Financial Planning in San Francisco, adds that it's crucial to create a solid investment plan to help achieve one's goals. "As a financial advisor, I work with my clients to develop an investment policy statement at the outset of our engagement. This outlines the client's investment goals and risk tolerance, which is a fundamental part of their financial plan. I believe that investing in business equity, or stock, is the best way to build wealth over the long term. That said, understanding a client's entire financial picture is essential to successful investment. The result is a diversified portfolio that promotes growth and provides for downside protection."
Structure Your Portfolio Around Dimensions of Returns
When new clients come in, their portfolios are almost never organized around a philosophy or strategy designed to balance risk and return. Instead, they are generally a collection of "stuff," assembled for various reasons. Maybe there are some inherited securities, or funds never re-allocated from an old 401(k). Maybe it includes expensive funds that a non-fiduciary broker collected a commission to sell. Often, clients cannot even recall or articulate why they own a certain investment.
This is understandable. Americans have been led to believe that everyone has the knowledge to be a successful do-it-yourselfer, despite no training or education in the science of investing. Other investors prefer to be hands off, and cede control of their portfolios to a commission-based broker (who generally bills him- or herself as an "advisor" or "planner"). These clients tend to have little involvement with the process of investment selection.
Not everyone has the time, interest or inclination to become super knowledgeable about his or her investments. Nothing wrong with that, but at the very least, it's imperative to understand that returns are driven by specific factors; that willy nilly collection of expensive "stuff" probably is not optimized for your unique situation.
Decades ago, it was more of a guessing game than it is today. Now, thanks to research by Harry Markowitz, William Sharpe, Eugene Fama, Kenneth French and others, we know there is a scientific way to derive returns, using specific asset classes.
It has a fancy name, "dimensions of returns." But it's actually a pretty simple concept. Over time, stocks return more than bonds; value stocks return more than growth stocks; small caps return more than large; and more profitable companies return more than their less profitable peers.
George Reilly, owner of Safe Harbor Financial Advisors in Occoquan, Virginia, uses visual tools to explain the need to invest in different asset classes. While the expected return of certain asset classes is higher over the long haul, that doesn't mean it will outperform in every time period, something Reilly points out to clients.
"I am a visual learner and like to use show-and-tell type of tools. We have a laminated version of one of the 'periodic table' type of colorful charts that shows asset class returns over 20 years or so," Reilly says.
"This type of chart truly shows the value of diversification as you follow a particular asset class by color across the years. One of my favorite things to point out is that in 1998 and 1999, large-cap growth funds were the top of the list, and if you decided to go big on that asset class you were in for a very unpleasant surprise in 2000 when it plunged to the bottom as the tech bubble burst and fixed income rose from the bottom to the top," he adds.
This concept dovetails with Reilly's show-and-tell example, as well as the idea of using dimensions of returns to your advantage. Back in our parents' or grandparents' era, investors basically had a choice between big U.S. stocks and big U.S. stocks. In other words, the investment choices were severely limited.
Today, with the advent of indexed exchange-traded funds and inexpensive mutual funds structured around dimensions of returns, investors have easy ways of accessing broader markets. In addition, it's easier than ever to purchase non-U.S. stocks and bonds through mutual funds and ETFs. Small stocks, too, are included in many of these inexpensive vehicles. This is a far cry from what was available as recently as 25 years ago.
However, it doesn't help that the financial TV channels and many financial publications continue to focus on large-cap domestic stocks, giving investors the impression that S&P 500 components constitute the entire market.
Jill Kismet, owner at Plan For Joy in Tucson, Arizona, emphasizes the need for broad allocation, given the yearly changes in asset-class performance. She also notes the ability to diversify easily and inexpensively.
"Year to year a particular equity or asset class can excel while others decline," she says. "Therefore, diversification is really a portfolio optimizer toward whatever gains or losses occur in the market over the long-term. Now more than ever, is it easy and cheap to diversify your portfolio by using passive index funds. Diversification coupled with index funds are a great equalizer for all personal investors seeking long-term wealth-building."
More From US News & World Report