By: Anthony Watson, Founder Thrive Retirement Specialists
Your investment portfolio is likely one of the primary assets you plan to rely upon to fund your retirement. As such, your investment portfolio must be structured and managed properly. No longer can you take the cavalier approach you once could when you were younger and saving for a time way off in the distant future.
An investment portfolio should begin to look differently heading into retirement for several reasons. First, volatility becomes much more of a risk factor as sequence-of-returns-risk is highest early in retirement when the portfolio is largest. The key to minimizing volatility and reducing sequence-of- returns risk is to ensure your portfolio is well constructed and diversified. Second, you cannot afford to take concentrated risks to try and hit home runs anymore because there is less time to rebound from mistakes now. Lastly, since you can’t swing for the stars when it comes to returns anymore, keeping as much of the return as you can becomes more critical. This means paying attention to fees that can eat away at your returns.
Portfolio Diversification
Diversification is an often misunderstood concept. Someone with just a single index fund could be more diversified than someone with 100 individual stock holdings. Diversification has nothing to do with the absolute number of holdings but rather the asset class exposures each holding represents. I believe there are nine distinct asset classes a person should have exposure to be maximally diversified: 1). U.S. Total Stock Market, 2). U.S. REITS, 3). Developed Markets Europe, 4). Developed Markets Asia-Pacific, 5). Emerging Markets, 6). U.S. Total Bond Market (investment grade), 7). Total International Bond Market (investment grade and U.S. dollar hedged), 8). U.S. TIPs, and 9). U.S High Yield Corporate Bonds (non- investment grade).
Noticeably absent from this list are alternative investments, commodities, and cryptocurrencies. Alternative assets are non-traditional investments like hedge funds and private equity. Alternative assets are complex, loosely regulated, opaque, and expensive investments that seldom yield a return commensurate with their true risk. Commodities are hard assets that do not produce a stream of income. As such, commodities are not worth including in a portfolio because they can’t be expected to provide the portfolio with a positive return above the inflation rate. Cryptocurrencies aren’t even an asset. Not only do they not generate income, but they also can’t even be used as raw material to build something of value.
Nine asset classes may not sound like a lot, but incredible diversification can be achieved through the right vehicles. For instance, using broadly defined index funds to represent each of the nine asset classes, one can build a maximally diversified portfolio giving them exposure to over 36,000 individual securities across all investable 44 countries.
Adopt a Passive Investment Philosophy
There is a reason professional investors from Warren Buffet to the late John Bogle champion the benefits of passive investing. There are many tangible and intangible benefits to reap from adopting a passive investment philosophy. First, individuals can often save more than 1.00% alone based on the average expense ratios of the funds being held in a portfolio. Based on the average expense ratios listed in the Investment Company Institute’s® 2020 Factbook, a 50% stock and 50% bond portfolio would carry an average expense ratio of 1.18%. Using only low-cost index funds, you can build an efficient, diversified portfolio like the one previously discussed for a weighted average expense ratio of less than 0.10%. This 0.90% difference drops right to the bottom line of your return. Second, a passive investment strategy requires less trading than an active investment strategy, leading to lower transaction costs and greater tax efficiency. Lastly, a passive investment strategy is easier to understand and implement, eliminating much investor stress and anxiety.
No one has a crystal ball to predict what will happen in the short term. But over a longer time period, investment returns tend to behave much more predictably as the risk-return relationship plays out. All investments have a specific risk and return profile that they eventually follow. This concept is known as reversion to the mean. The problem is it is very difficult to time this reversion, so it does not make economic sense to pay extra money in the form of a higher expense ratio to bet on active managers. Even if you could predict what could happen, you would have to predict when it will happen and how markets would react to the event. You can see where the probability of success shrinks with each active bet.
Minimize Your Total Cost of Investing
There are two components to your total cost of investing. The first component is your portfolio’s weighted average expense ratio. The second component is your financial advisor’s management fee (assuming you use one). Every mutual fund or exchange-traded fund (ETF) charges what’s known as an expense ratio. A fund’s expense ratio is not an explicit charge you pay; instead, it is a portion of the return held back by the fund company to pay their expenses. Fund expense ratios can be as low as 0.02% or as high as 3.00% or more in some cases, and these fees can end up taking a massive bite out of your return. To figure out your weighted average expense ratio, you will need to look up each holding you have in your portfolio and the weight of that holding within your portfolio. You can then calculate your weighted average. The next component is your financial advisor’s management fee (if you use one). Now, let me say that I believe advisors add value to their clients in many ways, but the price you pay for that value can vary greatly. Taking the time to understand how your advisor is compensated, if you don’t already know, will help you determine this component. Some advisors charge commissions, some charge a % of assets under management, and some a flat fee.
These tried-and-true strategies may not be “fun and exciting,” but there is less time to recover from mistakes now. It can be hard giving up that Apple, Tesla, or Amazon stock, but a large permanent drop in a single security that represents a material portion of your portfolio can cause irreparable damage to the sustainability of your retirement plan once you retire. Who would have thought it possible that General Motors, once the largest company in the U.S., could go bankrupt? But they did. Remember Enron? They looked like an excellent investment until the accounting scandal. Stay away from company-specific risk that can be diversified away using a low-cost, diversified index fund portfolio.