You know that these goals can be expensive, and that you’ll need to save and invest in an intelligent way to reach them all on your timeline. But if you’re relatively new to investing, you may be unsure about the best way to invest your savings, so that you generate enough return without taking any unnecessary risks.
If you believe the financial media – whether it’s CNBC on cable television, Marketwatch online, or Kiplinger’s or Money magazines on your newsstand – the key to a happy and successful investing experience is picking the right stocks or funds at the right time.
Instead, let’s explore, in a bit of detail, the concept of asset allocation. It’s one of the foundations of successful investing. It’s key to your investing growth, and it will help you redefine what you consider the best investments for young professionals.
1 – Most of Your Return is Determined by Asset Allocation
Academics have been studying financial markets since the 1960s. One of the most important conclusions to come out of that research is that your asset allocation decision is the most important factor in explaining your portfolio’s performance.
This means that how you choose to divide your savings up between categories (like stocks, bonds, real estate, cash, etc) is more important than which good (or bad) funds you pick in each of those categories.
Let’s say you’re an engineer at Intel in Hillsboro, Oregon or Folsom, California, an executive with Nike in Beaverton, Oregon, or a doctor with Oregon Health & Science University in Portland, Oregon, and you’re chatting with a colleague about the relative performance of your 401(k) accounts. If you find that you’ve had different results, it’s almost certainly due to the fact that your asset allocations were different, rather than because you picked Fund A in US Large Cap Stocks and your colleague picked Fund B.
2 – Stock-Picking is a Loser’s Game
Once you understand that most of your return will be determined by your asset allocation decision, you no longer need to worry about trying to find the best active manager for each asset class you’ve selected for your portfolio.
In a nutshell, active managers believe it’s possible to consistently earn returns that are better than those of the market (or a particular benchmark against which their performance is measured), by attempting to identify mis-priced securities and/or timing the market. Passive or index-oriented managers, in contrast, believe that the market is fairly efficient in pricing securities, making out-performing the market consistently very difficult.
There have been literally hundreds of peer-reviewed research papers written on the subject of the performance of active managers over the past several decades, a number of which have earned their authors Nobel Prizes for their work. What does the research show?
First, on average, active managers under-perform the market. In a well-known 1991 article in the Financial Analysts’ Journal, William Sharpe showed that in an investing world filled with active and passive (or index) investment managers, the combined performance of the active managers has to equal the passive managers’ performance, less the difference in fees charged by the managers. Why? Because before fees, passive/index managers will by definition own a pro-rata share of all investments in the market, and so earn the exact same return as the market itself. That leaves the exact same for the active managers, in aggregate – they also get the market return, before fees.
Second, even if you manage to find an active manager who’s beaten the market for several years in a row, it’s basically impossible to tell whether that out-performance is due to luck or skill. Imagine that instead of picking stocks, the active manager was instead just flipping a coin. If he managed to land on heads 5, 10 or even 15 times in a row, you’d still attribute that to luck, and not to some unique coin-flipping ability. It’s the same with investment results. Consistent market- or benchmark-beating performance is uncommon, and so infrequent that being able with certainty to attribute it to skill isn’t possible. Bill Miller, formerly a fund manager at Legg Mason, is one of the most recent examples of a fallen star active fund manager.
Third, while it’s easy to identify market-beating performance after the fact, it’s very difficult to do so in advance. As the saying goes, “past performance is no guarantee of future results”. Standard and Poors, a leading investment resource for index and benchmark data, regularly assesses the performance of active investment managers. In their December 2019 report, they again concluded that “…historical performance is only randomly associated with future performance”.
3 – With Asset Allocation, You Can Both Diversify and Simplify
One of the keys to successful investing is understanding what diversification is, and why it’s important.
In a nutshell, diversification is all about owning a variety of investments that are expected to perform differently over time. Think about stocks doing well when the economy is growing, with bonds and cash performing better when the economic cycle slows down. Now, if you had perfect foresight – or a crystal ball – you would obviously only own investments that are going to perform well. But, as we know, active management in general has a dismal track record.
A properly diversified portfolio will include a mix of stocks, bonds, real estate and cash, and, within each of those broad categories, allocations to sub-categories (or “asset classes”) – like US small company stocks, international value stocks, US government bonds, and so on.
By combining a number of asset classes together in your portfolio that have different risk and return characteristics, you’ll optimize your portfolio’s risk/return relationship. You’ll earn the most return for a given amount of investment risk taken. That’s why diversification is sometimes called the only “free lunch” in investing – it costs nothing, and improves your results.
By choosing not to pick individual stocks and instead opting to use mutual funds or exchange-traded funds that own hundreds or thousands of securities in a given asset class, you can effectively diversify your portfolio with zero effort.
Investors are increasingly interested in expressing their values, and their commitment to environmental and social causes, through their investing. Fortunately, the financial services industry has recognized this demand and has responded. At Springwater Wealth, for example, we can implement our low-cost, broadly diversified investment strategies with socially responsible, sustainability, or carbon-free overlays applied. With a growing number of asset class-oriented and index funds available in this area, you don’t need to sacrifice investment performance or suffer high fees to invest with your values.
Do you have questions about investing, or about making smart choices in your 401(k) plan at work? Contact us today to see how our team at Springwater Wealth can help you develop a solid plan for your financial future.
4 – Asset Allocation Doesn’t Require Constant Management
If you make the smart choice to prioritize asset allocation as part of your investing growth strategy, you’ll relieve yourself of a lot of the stress, pressure and unnecessary activity that comes along with an actively-managed approach.
You won’t need to monitor every holding in your portfolio on a daily basis, because you’ll probably own no more than a dozen or so mutual funds or ETFs, each of which will represent an asset class, and will own hundreds or thousands of stocks. So, you won’t need to worry about the latest earnings announcement, product flop, or management reshuffle at a particular company. By building out your portfolio with funds, you eliminate these types of company-specific risk.
Your initial asset allocation should reflect your goals, your investment horizon, your risk tolerance, any need for liquidity, and perhaps some other, personal constraints. But you really won’t need – or want – to change your target asset allocation unless there’s a significant change in your circumstances. Asset allocation shouldn’t be influenced by short-term market fluctuations or other temporary economic conditions.
You will want to rebalance your portfolio periodically, ideally as part of a disciplined, structured process. In short, rebalancing is nothing more than the process of systematically bringing your portfolio’s actual allocation – which, because of differing performance from the asset classes you own, will have drifted away from its target – back in alignment.
Embracing asset allocation as the foundation of your investment strategy gives you the best odds of meeting your goals, and of enjoying a successful investment experience.