As a Certified Financial Planning Professional (CFP), people ask me how they should invest for retirement. Their next questions often focus on what investment is best right now, and how they can get into the “Next Big Thing.” The focus on an individual investment misses the mark, though. It’s more important to start early and have a long-term financial plan. As we age, most people find that their goals change from when they were young. Financial growth over everything else is no longer as important. Even before the transition to retirement income begins, retirement planning requires a reconsideration of the risk level in your portfolio and often a reduction of its market volatility. The planning doesn’t end when you retire; you will need a retirement distribution plan. How you withdraw your money is just as important as how it should be invested. That way your investment assets can give you the lifestyle you want to live long after you end your career.
One of the most effective ways to reduce risk is to increase the diversification of your investments. How to do this is often misunderstood. Owning 10 different growth stocks does not mean one is diversified. A diversified portfolio uses many different asset classes and a wide variety of investments in each Asset Class.
1. What Are Asset Classes, Correlation, And Allocation?
An asset class consists of investments that are similar in structure and share risk characteristics. The investments in an Asset Class tend to act the same over the long term, although individual investments can wildly out-perform the group or fail fantastically. The broadest way of looking at this is
- Stocks, which are partial ownership in a corporation
- Bonds, which represent the debt of a company or government
There are alternative assets, like real estate, precious metals, and commodities. Each of these broad classes can be broken down into smaller and smaller groups of investments. From the U.S. viewpoint, we can first think of domestic and foreign stocks. Then break them into the largest companies and those that are smaller. We then look at what kinds of companies we might want to invest in.
Do we want growth companies that can produce substantial gains as well as possible losses? Would stock in value-oriented companies that offer income through stock dividends and often have a lower level of volatility be better suited for your portfolio needs? Which is best for you depends on your risk tolerance and long-term goals.
With some exceptions, most stocks tend to go up and down at the same time. Sometimes it’s one part of the stock market or one part of the world that is out of sync, but over the long term, generally, they all act similarly. That’s why we want to add other asset classes into the mix. Bonds are generally viewed as lower in volatility than stocks, but that is not always the case. Some bonds are riskier than most stocks can be, but overall, they are accepted as less volatile than stocks. Bonds react differently to economic factors than stocks. They can rise when stocks fall, often offsetting the losses in other parts of a diversified portfolio. This is called correlation, and the higher the correlation the more your investments act alike. Other asset classes like precious metals such as gold and silver can also add to portfolio diversity. These and other classes such as commodities (oil, wheat, corn, and, yes, even grocery items like frozen orange juice) and real estate have low correlations to stocks and bonds.
Investment professionals, portfolio managers, and financial planners agree that a mix of all these make a portfolio diverse. A portfolio can be made up of individual stocks and bonds, mutual funds, or ETFs. No matter what type of investment, it is important to have multiple asset classes. A broad mix, in the right proportions, means everything isn’t going in the same direction at the same time, reducing volatility risk. And lower risk is important to retirement planning.
The investment mix is called your allocation, and the right allocation for your risk level is a key aspect of a successful retirement. Investing is not all or nothing; there are various levels of risk. The right allocation will allow an investor to stay invested over the long term. If you accept that markets go up and down, the right risk allocation can keep you within your comfort zone. Not everyone is aggressive; investors can be moderate or even conservative. Remember a conservative investor is not someone that’s only in cash. They are an investor who wants lower risk and is willing to accept lower returns for that decrease in volatility.
2. Who Is Jay Kloepfer?
All this leads me to introduce you to Jay Kloepfer. Who is he and why is he important to your investment portfolio? He is the executive VP of Capital Markets Research Group and was a Senior Economist with Standard and Poors. Jay is the author of the Callan Periodic Table of Investment Returns, which he created in 1999. Commonly referred to as the Callan Chart; it shows returns of different asset classes over the last 20 years.
The chart shows that no asset class is always the best. Often what’s best this year is far down the list the next. Diversification is the key and helps you average the risk and returns of the different asset classes.
3. Am I At Risk Of Emotional Investing?
In my work, we often see people come to us that have been doing it themselves. They were scared out of the market when there was a steep drop and did not know what to do next. They have jumped out of the market at the worst possible time, often near the bottom, waiting until the conditions improve. By doing this they, miss a good part of the positive market cycle. We call this Market Timing, and it almost never works better than staying the course.
Individual stock Investors often stay too long at the punch bowl. They have no plan for when they should sell a stock. Owning a stock means you need to keep track of more than what it has gained — you need to keep reevaluating what is going on. Stock investing used to mean a buy and hold strategy where you buy it and keep it forever. Three examples where that strategy failed are Kodak, AOL, and Blockbuster Video. They were the top companies in their field, until they weren’t. You need to know how much you want to earn on each stock, how long you will wait to get that return, and how much you are willing to lose along the way before you sell it. You also need to keep reevaluating these factors over time.
If you are not doing this and putting in the research time necessary to own individual stocks, you are just betting with your gut feelings. In cases like that, it is better to let a professional manage your investments for you; otherwise, your odds might not be better than they are in Vegas.
4. Is This An Investment De Jour? (And What That Has To Do With Your Local Diner’s Fish Special)
View “hot” investment tips with skepticism. What is the reason this person is telling you to buy? Sometimes it is that they want to help push up the price before it spoils like a 3-day-old fish in a diner’s cooler. If it does not sell, it goes bad, just like the stock tip. Recently we have seen meme stock investing become a thing: stocks that shoot to the stratosphere and fall back to earth just as fast because of an online forum. Get in at the wrong time, and the fall will hurt. Stocks like these are often over before you hear about them. They have made some rich while many others have lost everything. Fantastical returns often come with fantastic risks. If you are comfortable with that, have experience, and want it as part of your portfolio, the advice I’m sharing in this article is probably not for you.
Retirement means that high-risk investing is not part of the plan. Making up for losses is difficult when you are taking distributions to live on. The young have decades to recover from a major loss due to a bad investment decision; retirees don’t. I recommend that people not worry about the dollar they didn’t make in an investment they think they missed. Know who you are as an investor and stay within that risk tolerance. Stay diversified, have a long-term plan, and stick to that plan. Keep the gambling for that trip to Vegas.
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