- Before you can decide HOW you should invest your money, you first need to decide WHY you are investing your money.
- An investment plan that is tied to a long term goal such as saving for retirement decades down the road will need to look a lot different than a short term goal such as saving for a down payment on a house that you want to be able to purchase in 2 or 3 years.
- Generally, the longer the time frame you have to reach your investing goal, and the more money you need to pay for that goal, the more aggressive i.e. more risky your portfolio needs to be.
- The shorter the time frame, and the less amount of money you need for your goal, the more conservative, i.e. less risky your portfolio needs to be.
- Why is this?
Investment Risk Vs. Return
- Generally speaking, the riskier the investment, the greater the long term return it will achieve because people need to be able to expect higher returns in order for them to be willing to take on this additional risk. These types of riskier investments will have more volatility, and can have greater negative returns than more conservative investments over shorter time frames. But over longer time frames, they should generate higher returns.
- The more conservative the investment, the less likely you will experience negative returns, but because you aren't faced with the volatility of riskier investments, your returns will be lower and your portfolio wont grow as much over the long run.
- So using the previous examples, if you are decades away from retirement, the investments you use to fund your retirement goal need to be more aggressive. This is because you have enough time to ride out the ups and downs your portfolio will experience, and the greater long term returns will give you a better chance of having saved enough for retirement.
- If you are saving to purchase a house in 2 or 3 years, you can't afford to be too aggressive with how you invest those savings because you don't have time to recover from any losses that a more risky portfolio may experience.
- So what makes a portfolio more or less risky? It's asset allocation. The term asset allocation describes what percentages of your portfolio are allocated to the 3 main investment categories: Stocks, Bonds, and Cash (also referred to as short term investments).
- As you can see from the chart below, over time stocks have higher risk so they generate higher returns. Bonds have less risk so they generate lower returns than stocks. Cash or cash equivalents have the least amount of risk so they generate the least amount of return.
- As mentioned previously, a longer term goal should be assigned a portfolio allocation that has a higher percentage of stocks and a shorter term goal should have a portfolio allocation that has a higher percentage of bonds and cash.
- Once you have determined what percentages of your portfolio should be in the stocks, bonds, and cash categories, you then need to decide which individual investments you want to purchase in order to create a portfolio that has the desired mix.
- There are multiple ways to invest in stocks, bonds and cash, with mutual funds and exchange traded funds (ETF's) being two of the most popular ones.
- Mutual funds and ETF's allow you to purchase a basket of stocks or bonds all at once instead of having to go out and purchase them individually. This allows you to diversify your investments in a more simplified manner.
- When it comes to investment selection, we believe on focusing on what you can control. You have no real control over the future returns of your individual investments, but you can control how much you are paying for them.
- For this reason, whenever possible, we suggest using low cost ETF's. In your employer-sponsored retirement accounts, ETF's are generally not available so try to focus on using low cost mutual funds when available.
- Once you have implemented your portfolio with the asset mix and investments that align with your goals, the next step is the most challenging...
- Don't make emotional decisions to change the asset allocation of your portfolio unless your goals or situation has changed. For most people, this is easier said than done.
Take a look at the chart below which shows returns of the S&P 500 over the course of multiple negative political and economic events between 1999 and 2018. Think back to how you were feeling about your investments during each downturn. With each event, the media made it sound like the world was crashing down, but look how the markets performed over the long run.
- Experiencing these types of emotions when it comes to investing is completely normal. The key is managing them so that you don't make mistakes that could cost you dearly in the long run.
- The average fund investor tends to consistently under-perform the overall markets because their emotions cause them to buy and sell their investments at the worst possible times.
- They end up buying stocks at their peaks and selling at their bottoms.
- This cycle can lead to substantially lower returns than if they had just stuck with the original mix of stocks and bonds that made the most sense for their goals...
- Jumping in and out of the markets and missing only a few days of returns could cost you thousands...
- If your goals or situation haven't changed, the only time you should make changes to your investments in your portfolio is when market fluctuations have steered your original intended asset allocation (and therefore your portfolio risk) off target.
- Rebalancing involves selling investments that have jumped in value and using the proceeds to buy investments that have not done as well. This may sound counter intuitive, but this actually helps you to buy low and sell high (good for returns) while keeping your original desired mix of stocks, bonds, and cash.
- In the below example you will see that during periods of high stock market returns, if you ignore your portfolio and never rebalance it, you will all of a sudden have a portfolio that has substantially more stock exposure and therefore risk, than you originally deemed appropriate.
Rebalancing Applies In Down Markets Also
- The opposite can happen during periods of stock market declines.
- During a stock market slump the individual stock holdings in your portfolio will lose value, which means you will find your overall portfolio containing a lower percentage of stocks and a higher percentage of conservative bonds. This makes your portfolio too conservative and reduces your ability to achieve the long term growth that you need to achieve your goals.
- Lets say for example you are supposed to have a 70/30 mix of stocks to bonds, but the stock market has under-performed recently and now your portfolio is at a 60/40 mix. The savvy investor would know to sell 10% of their bonds holdings (which haven't lost value like stocks because they are more conservative).
- They would then take the proceeds from selling those bonds and buy enough stocks (which are on sale) to bring their portfolio weightings back up to a 70/30 mix of stocks to bonds.
401(k) and 403(b) Contributions
- When it comes to deciding how to contribute to your employer-sponsored 401(k) or 403(b) there are a few things you need to know.
- You ALWAYS need to find out what your company match is. This is the percentage of your salary that your employer contributes on your behalf as long as you are making your own contributions. For example they may state that they will provide a dollar for dollar contribution up to 4%.
- This means if your salary is $100,000 and you are contributing 4% yourself, you will be putting $4,000 into your account over the course of the year and so will your employer. Since this is free money and basically a guaranteed 100% return on your contributions, you should always do everything possible to at least contribute enough to receive your full company match.
- Ideally, you are able to contribute a much higher percentage than that regardless of what the employer match percentage is. The more you save, the more likely it is you will be able to retire when you want to and a 4% contribution rate simply wont cut it.
- Nowadays, many employer plans are allowing you to make Roth Contributions. You need to find out if this is an option and decide if you should make your contributions in the form of Roth savings, or if it makes more sense to contribute in the more traditional manner of pre-tax contributions.
- What's the difference?
- Keep in mind that even if you contribute Roth money into your 401(k) or 403(b), your employer match will always be in the form of pre-tax dollars so it's common for people to have both types of money in their employer-sponsored retirement accounts.
- This is not an all or nothing choice. If your plan offers the option of Roth contributions, you can direct some of your contributions towards Roth, and some towards pre-tax contributions.
- All investing involves some types of risk. The key to long term success is to focus on what you can control. This includes your investments costs and your asset allocation.
- The number one obstacle when it comes to achieving your investment goals, is not political or economic events, its you.
- Keeping your emotions in check and approaching your investment decisions methodically will lead to long term success.
- At HCP Wealth Planning, we recognize this is easier said than done. The best way to do this is to always fall back to the plan.
- When you determine what portfolios make the most sense for you and how they should tie into your overall plan, you need to factor in the various potential market incomes, including poor markets.
- If the markets are causing you stress you should revisit your overall plan and make sure nothing about your situation has changed that would cause you to want to reconsider the amount of risk in your investments.