Forrest and Jenny both start at the XYZ Widgit Company on the same day. Their company 401(k) plan allows them to begin to make deferrals immediately. They are given either a hard copy enrollment book, or a plan website to enroll and make their investment decisions. There’s over 40 options in the plan!
So, what do they do? They look at the investment options and more often than not, they choose the ones with the best 5, 10, or 15 average returns. There is no advice available to them…It’s another SWAG situation (Scientific Wild A__ Guess).
Do those chosen options match their risk tolerances? What if Jenny is a Moderate Risk and Forrest is a Conservative Risk? If they are chasing returns, more than likely they put themselves into Aggressive investment options.
AVERAGE vs ACTUAL
You come to me with a newly acquired investment and you want my help. Let’s say that lottery ticket finally cashed in & you won $100,000. So, I put it to work using all my tools, such as risk tolerance questionnaires, time frame of the investment, liquidity needs, etc. All the things a prudent advisor must do for his clients.
I’m using an extreme example here, but I have a big point to make! This blew me away the first time I saw it, by the way…
Here’s how it plays out for the next four years:
- YEAR 1: $100,000 acct balance 100% annual return = $200,000
- YEAR 2: $200,000 acct balance -50% annual loss = 100,000
- YEAR 3: $100,000 acct balance 100% annual return = $200,000
- YEAR 4: $200,000 acct balance -50% annual loss = $100,000
So we’re sitting down for our periodic review, and we’re at the end of our fourth year together, and you look at me and say:
“Brian I’m not happy…I’ve given you 4 years, and I’ve still got the same amount of money I gave you to start with.” …and you are correct. Your ACTUAL RETURN is ZERO.
However, I do some math, and come up with this:
100% – 50% +100%- 50% = 100%…divided by 4 = 25% ANNUAL RETURN.
So I look at you and say, “Wait a minute, you are dissatisfied with a 25% average annual return? You should be thanking me!” Getting a little steamed right now? You should! This happens to most everyone that do not understand the difference between AVERAGE & ACTUAL.
This is the “fallacy of chasing investment returns”. Refute it all you want…recalculate it 1000 times…this is real and it happens all the time when you’re looking at investment returns as a benchmark to make financial decisions.
So, what do you do? Well, would a Nobel Prize winning study in Economics interest you? In those 401(k) enrollment books, did you ever see pie charts that look somewhat like this?
This is called “Modern Portfolio Theory”, and Harry Markowitz won the 1990 Nobel Prize for this concept. The study said that of an investor’s success in the stock markets:
- 91.5% was attributed to how their money was diversified over a broad array of asset classes based on their period & risk tolerance (Moderate Risk Portfolio shown above)
- 4.6% was attributed to what investment chosen (a.k.a stock picking or chasing returns)
- 1.8% was attributed to Market Timing
- 2.1% was attributed to other factors.
This study has become the benchmark of the financial advisory world. That risk tolerance questionnaire I mentioned above is one of the key components of this method.
Day trading is sexy and everyone wants to brag how great they are doing and that they bought Apple at $6/share. However, based on this study, you can see the minimal success this brings over time.
Modern Portfolio Theory Used In Your World
Given the problems I’ve show you regarding chasing returns and picking your own investments, you’re probably wondering if there are solutions. Yes, there are. The pie chart on the previous page is uniquely tied to that Nobel Prize winning study. I call these a “fund of funds” approach.
These “fund of funds” originated in the 401(k) world. In seeing the problems I’ve pointed out, and realizing that the plan providers (employers) have a fiduciary responsibility to their participants, these “fund of funds” were created to help their participants make the best investment decisions they could, given the lack of advice available to them.
These funds also “manage the fund managers”…meaning if one fund manager isn’t performing to the levels set out for their asset class, they can be replaced. Look at the pie chart. That dark green sliver is the “SHORT TERM BOND portfolio”. It makes up 20% of the overall allocation.
If the committee overseeing this Moderate Risk Portfolio determines that this particular fund manager is not performing, they have the ability to put another fund manager in their place. This keeps the overall fund running at its optimal level. As an investor in this fund, it’s highly unlikely you would ever know this…unless you enjoyed reading a lot of fine print late at night because you can’t sleep!
You might know them today as “Target Date Funds” or “Lifestyle” funds. Lifestyle funds normally offer 5-6 investment models to choose from…from Conservative to Aggressive. This is where that Risk Tolerance Questionnaire comes into play.
You honestly answer the questions on the questionnaire…it gives you a score, and that score equates to a particular model. If your score equals a Moderate risk tolerance, then you allocate 1oo% of your contribution (and the employer’s match, if available) into this Moderate portfolio.
You can see in the pie chart how each dollar you contribute is allocated. Remember 91.5% of your success is attributed to how your money diversified over a broad array of asset classes based on their period & risk tolerance. It takes the guessing game out of investment selections, and helps in “matching your money to your emotions”.
Target Date Funds are similar in their asset allocation approach except they will adjust as you get closer to your targeted retirement date.
Keeping it simple, this is the year 2020. You are 40 years old. Your target date for retirement is 30 years from now. There are several these funds with different “targeted” years. 30 years from now is 2050. If you follow the strategy, you would put 100% of your allocation into this Target Date 2050 Fund.
As you get older and closer to that retirement target date, the fund allocation, by design, will reduce the allocation in stock investment and increase the allocation into fixed income investments.
That investment strategy follows this chart perfectly.
Observations & Thoughts
It’s the norm with me to look at both sides of any strategy offered to my clients. Personally, I really like each of these “fund of fund” strategies. It takes the guess work out the equation. Two observations, one on each strategy. If you chose the Moderate Risk Lifestyle Fund, it will always stay a Moderate Risk. It never changes.
So occasionally it makes sense to revisit the Risk Tolerance Questionnaire & see if you still need to be Moderate. Perhaps you are in that pre-retirement stage of your life, and you are now a Conservative Risk Tolerance. Well you know the answer to that one. You make an allocation change so that 100% of your account balance & 100% of your new contributions will go into that fund.
With the Target Date Funds, you should choose what that targeted date means. Many plan participants assume their date is Age 65…meaning at that date, the fund allocation will be very, very conservative.
I tend to disagree with this, primarily based on longevity. Remember when I said that a couple, each age 65, there’s a 50% chance one of them will live to age 90? This is what I’m referring to.
If you’re planning to live a long life, maybe your target date needs match something other than retirement. I’m not saying take more risk. Quite the opposite. I’m saying that outliving your money is a very relevant topic in today’s world. If you are too conservative in the DISTRIBUTION phase of your life, it might put on this path.
“The greatest sin a financial advisor can make is allowing his client to run out of money!”