In part one of this series, we examined the two main components of portfolio fees:
1. The internal expenses charged by mutual funds and exchange-traded funds, and
2. The cost of advice associated with a professional fiduciary financial advisor.
Transparency is of the utmost importance. If you feel that your wealth management firm can’t clearly articulate what it is charging, that’s a red flag. You, as the client, should already understand what you are paying and should never have to ask out of confusion. Given the often-significant effect of investment-related expenses, take the time to understand your costs and benefits. While virtually impossible to command your short-term returns in the stock market, you can control your costs. Fortunately, you also have a good degree of sway with the risk of your portfolio.
The shorter the time period when you will begin drawing income from your portfolio (i.e., your time horizon), the more important a risk-focused approach becomes. Think of risk as your pain tolerance to lose money over short periods of time, understanding that the longer your time horizon, the greater your probability of positive returns. Time reduces the risk associated with investing in a well-diversified portfolio, and volatility simply becomes noise over the long run (i.e., 10-plus years).
There are many “reasons” not to invest in the stock market. If the current market downturn has you worried, try to remember your state of mind during the mortgage crisis. When the stock market was down -46% did you sell, or recognize the Great Recession as a buying opportunity? If you waited it out for roughly four years, you would have recovered all of your loss. Or what about the bursting of the tech bubble? That full recovery would have required you wait about four years as well. What’s your time horizon?
You can control portfolio risk, expenses and even taxes (which I’ll explore in my next article). Risk is the single most important concept in portfolio management. There are many good online tools and financial advisors that will help match your portfolio with your risk tolerance and goals in a decisive and understandable way. It’s human nature to want maximum returns with minimal risk, but that is simply not reality.
For someone approaching a point in life relying more on income from investments than from a job or salary, risk starts to really matter. “Set it and forget it” is a great strategy when you have a lot of time, but as you begin taking distributions in a declining market, your portfolio value could get crushed.
One solution to the quandary of finding the sweet spot in how much of your portfolio should be invested in stocks versus bonds versus cash is to have a risk number, confirm that you can meet your lifetime financial goals with this risk number and have the discipline to maintain it. Sounds easy, right? It is easy, but first you need to make sure your portfolio is truly aligned to meet your income needs along with how you personally view risk.
What Is My Risk Number?
Think of your risk number as a driving speed. If you are driving 85 miles per hour, you’ll get to your destination more quickly, but the risk of an accident or getting a speeding ticket also rises. If you go 45 miles per hour, that would be a much safer speed, and you will still get to your destination. But what if you are going 45 miles per hour in a 65 mile per hour zone? In this case, being too conservative equates to being in your 20s or 30s and investing from a place of fear.
The current stock market hit the brakes hard after more than 11 years of strong bull market. Historically speaking, the market has a 20% or greater decline roughly every 7.5 years. Reevaluating the current risk/reward structure of your portfolio is smart. The key is to find your sweet spot.
A good rule of thumb to determine your risk/reward has always been to subtract your age from 100, providing a rough estimate of how much you should be invested in stocks. If you’re 30, for example, an allocation of 70% stocks and 30% bonds and cash might be a good starting point. While this is helpful, it ignores your personal risk tolerance, or “pain threshold,” to short-term losses. There are many online risk questionnaires that merge your personal risk tolerance with your age, time horizon and other goals to help determine your optimal asset allocation (aka risk number). More sophisticated investors might look at multiple asset classes to diversify even further, such as gold, real estate, managed futures, annuities, private equity, art and collections.
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Rather than attempt to outsmart the market or focus mostly on the performance of your portfolio, ensure you are properly managing and aligning your risk, as well as understanding the fees associated with your portfolio.
In my next article, I’ll address what you need to know about investment-portfolio-related taxes.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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