Wall Street Doesn’t Have a Crystal Ball
Contrary to what Wall Street’s very effective marketing would have you believe, those who “beat the market” in the short term do so because of luck, not skill. Academic research has shown that there is a very low probability -- less than 3% -- that any one broker, money manager, or investment newsletter can pick investments that consistently outperform benchmark market averages (such as the S&P 500) over long periods of time (10 years or more). Those odds are about the same as the odds of throwing “snake eyes” at a craps table in Vegas. What is the probability that with the money you have to invest today, you can identify the lucky broker, financial advisor, or mutual fund who will consistently roll snake eyes and beat the market for the next 10 or 20 years? Very slight. Lesson learned: Avoid actively managed investments; stock picking and market timing are losers games.
One Size Doesn’t Fit All
An advisor who takes the time to understand your needs and risk tolerance will recommend diversifying and allocating assets amongst various types of investments consistent with your goals and risk profile. Studies show that over 90% of your investment returns depend on how your assets are allocated among different investment classes, while only about 2% is due to the specific stocks, bonds and other investments you choose to buy. Lesson learned: An advisor should spend the time to learn your particular circumstances, and tailor investments to fit your own risk tolerance profile. Run, don’t walk, from any advisor who tries to sell you something without first learning about you and your risk tolerance, who has the same solution for everyone, or who recommends putting all your assets into a single type of investment.
Wage War on Fees, Expenses and Commissions
Over long periods of time (10-20 years), well diversified portfolios have returned approximately 10% per year. Fees, expenses and commissions, imposed year after year, substantially reduce the long-term net investment return. The average expense ratio for actively managed mutual funds is approximately 1.5%. Similar or higher charges are assessed in “managed accounts” or “wrap accounts” where the investor is charged a fixed percentage of the portfolio rather than commissions on each trade. Because of the miracle of compounding, even a small difference in expenses charged against your investments can make a significant difference in the final long term investment results. Additional fees, commissions, and expenses, by themselves, can make it difficult to “beat the market.” Lesson learned: Keep the fees and expenses charged to your portfolio as low as possible. Avoid advisors who are paid on commission.
Don’t Chase Last Year’s or Last Month’s Winners
Mutual funds, Wall Street firms, and financial newsletters love to tout their recent successes. Investors flock to the fund, firm, newsletter, or investment category with the highest recent returns. But what happened in the past is a poor predictor of what will occur in the future. One study suggests that only 12% of the top performing investment managers for a particular year will be among the top performing managers the following year. The same historical reality that applies to stock picking applies to recent “market beating” firms and mutual funds -- the fund or firm that did well last year is not likely to repeat that success the next year, and highly unlikely to consistently outpace its peers for long periods. Lesson learned: Don’t chase recent winners.
Be Leery of Investment “Products”
Wall Street loves to sell “investment products.” These come in a variety of forms, including limited partnerships, investment trusts, variable annuities, variable life insurance, mortgage backed securities, and others. Some of these products cobble together investment and insurance concepts in a single package, to be sold as something that will supposedly cure one or another investment risk, or provide a benefit, such as life insurance or a guaranteed return. Often, these products pay the highest commissions to brokers and insurance agents. These products are suitable for some people, but are often too costly or complicated to be appropriate for most investors. Lesson learned: Be leery of “investment products.” Look carefully at the fees and expenses, and if the investment is very complicated, ask yourself whether you should risk your hard-earned money in something you don’t understand.
Make Sure Your Money Lasts as Long as You Do.
In retirement, many baby boomers suddenly will have access to significant lump sums of money, accumulated through savings, pensions, IRA’s, and 401k’s. There is a temptation to spend those assets freely, without considering that those funds may have to last 20, 30 years or more. It is critical for the investor to structure their retirement investments, and any withdrawals from retirement funds, so as not to outlive their money. As a rule of thumb, a withdrawal rate of 4% or less, adjusted for inflation, will increase the chance that there will not be a shortfall. Of course, each investor must consider their life expectancy, the composition of their portfolio, any other sources of funds (such as Social Security or company pensions), and their spending habits. Lesson learned: The higher the withdrawal rate from your retirement assets, the greater the risk you will outlive your money.
Avoid All the Noise and Invest in Index Funds
An index fund seeks to match the returns of a specified benchmark by buying representative amounts of each stock in the index, such as the S&P 500 or the Wilshire 5000. Other index funds focus a particular industry, or a particular geographic area, such as the telecommunications or health care sectors, or the leading publicly traded companies of South America or Japan. There are also index funds that track corporate government bond indexes. These funds don’t try to “beat the market,” they “meet the market,” by investing in the securities comprising the benchmark index. Lesson learned: Allocate your investments among a variety of national and international equity and bond index funds. Those seeking more risk should consider increasing their exposure to equities, while those desiring less risk should increase their bond and cash balances. The particular allocation suitable for you must be based on upon your particular risk tolerance, goals, and financial needs.