If you haven’t checked out the previous posts on Investing for Retirement, you might want to read up on them before continuing. They’re linked below:
Investing for Retirement Pt. 1 – Bonds
Investing for Retirement Pt. 2 – International Stocks
Investing for Retirement Pt. 3 – US Stocks
Investing for Retirement
History has shown that mixing those three types of investments in your portfolio can increase your risk-adjusted returns. Basically, you need to have a diversified portfolio to get the most bang for your “risk buck”. There are certainly more types of investments you can add to your portfolio. For example real estate, commodities like gold, silver, and oil, or cryptocurrencies. However, if you’ve got both foreign and US stocks along with bonds, chances are you’re well on your way to being fairly diversified.
While there is no “one-size-fits-all” mix of stocks and bonds that should be applied to everybody, there is an optimal portfolio for you.
In the past, investors have been given rules of thumb, like taking the number 100 and subtracting your age. That number is the percent of your portfolio that should be allocated towards stocks, while the remainder is allocated in bonds. Thus, the older you get, the more conservative your portfolio should be. This might be better than throwing a dart while blindfolded, but maybe just slightly. If these rules of thumb are outdated at best, and bad advice at worst, how are you supposed to know how to be invested?
Risk Tolerance
If you wanted to build an optimal diet plan for yourself, one that would maximize my life expectancy and make your body run like an efficient machine, you might need to make some pretty drastic lifestyle changes. But what if you like beer and enjoy going to happy hours on Fridays? A dietician could look at your health history, genetic makeup, and craft an optimal plan for you to maximize your health. And it likely would consist of lots of boiled or baked meat and vegetables. You might understand that would be better for you. But there might not be a very chance that you’re sticking with that for more than a few days, tops, if it wouldn’t fit in with your lifestyle.
Similarly, we can build a financial plan for someone, and based on a Monte Carlo analysis, infer the optimal mix of stocks and bonds for someone. However, if we suggested to a client that they should be invested in a 70% stock, 30% bond portfolio to maximize their financial health, and then at the first sign of volatility they call us in a panic wanting to sell their investments and go to cash, we’ve failed to take into account whether or not that portfolio fits in with another type of lifestyle, their risk tolerance.
Lao Tzu wrote, “He who knows others is wise. He who knows himself is enlightened.” Know your risk tolerance when it comes to investing. Take a risk tolerance quiz here.
Identify Your Goals
If you don’t know where you’re going, how will you know when you’ve arrived? When dealing with retirement plans specifically, we like to break down total annual spending into different “goals.” We’ll have a goal of how much someone wants to spend per month on normal, day-to-day things like food, entertainment, the basic necessities. Once we’ve established what that will cost, we can build on other goals, such as how much someone wants to spend on vacations, or what do they want to give to charities. Without this information, we can’t know what you need your money to do for you.
Once you know what your money is for, then you can begin to look at which mix of stocks, bonds, and other investments will give you the highest probability of meeting your goals.
Have a Plan
The investment plan doesn’t need to be a static mix that never changes. Nor does it need to perfectly time the market. You should be aware of the different risks that exist. Market risk is usually described as the chance that an investor loses money due to things that impact the overall financial markets. Inflation risk is the possibility that your returns fall behind long-term inflation rates, losing your purchasing power. Interest rate risk is the possibility that you buy a bond one day, and the next day, interest rates go up, meaning your bond is worth less as it pays a lower rate. Risk is everywhere. It’s not just in stocks, although that’s what most people focus on. It’s the one that you feel the most when you open your quarterly statement and see a minus sign in front of a number, or red ink instead of black.
Risk and Your Financial Plan
There’s another risk, called sequence-of-return risk. This is particularly scary because you (mostly) can’t control it. It’s the possibility that you retire with your nest egg, only to have the market crash underneath you early on in retirement, digging a big hole for yourself to climb out of. Compounding the problem is when you are taking withdrawals from your portfolio as the market continues lower and lower.
In my mind, that isn’t the biggest risk in investing for retirement. The biggest risk (and this is just one financial planner’s opinion) is not achieving your financial goals. Day-to-day volatility in your accounts is not risk. That’s the price of admission to investing. The real risk is running out of money before you die. It’s having no money left to pay for treatment for chronic illness in your 80’s, and becoming a burden to loved ones. While there are no guarantees that life will go according to your best-laid plans, you can stack the odds in your favor by doing financial planning. Once you have your goals clearly defined, and you’ve examined your tolerance for market volatility, you can begin to piece together the investment plan. It’s not a silver bullet for everyone, but it will be your silver bullet.
Portfolio diversification can be a tricky thing, and we’re here to help. Our financial planners will review your portfolio, stress-test it, and report back to your potential risks and opportunities. If you’re interested in this process, feel free to give our office a call any time at 913-393-1000 or schedule a complimentary consultation below and we will be in contact to schedule a time with you.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.