As a young professional whose income is increasing as your career blossoms, it’s important that you make smart decisions around saving and investing for the future. We highlighted a number of these smart decisions in a previous writing.
But it’s equally important – if not more so – that you avoid making some critical mistakes that can impact your ability to achieve financial security, reach your goals, and accumulate wealth for yourself and your family. Let’s explore a few important investing mistakes that young professionals should avoid.
Mistake: Not Understanding What Drives Portfolio Returns
The financial services industry is nothing if not a great marketing machine. Major banks, insurance companies, and brokerage firms collectively spend billions each year on advertisements intended to convince you to buy their products and services. Indeed, in a very real sense the financial services industry is a massive product delivery channel.
Much of that advertising is designed to get you to “act” – whether it’s buying or selling often doesn’t matter. The industry knows that a steady investor is an unprofitable investor, and so you’re bombarded with triggers like “10 Hot Stocks to Buy Now”, “Buy These Funds for Your Retirement Today”, and so on.
Well, we’re going to let you in on a little secret here – it’s not actually picking the right stock or fund, or timing your (buying or selling) trades right that will determine your success as an investor. Instead, the primary driver of portfolio performance is asset allocation – in layman’s terms, getting the “pie chart” for your portfolio right.
Asset allocation is the process of dividing your investable dollars across broad categories – like stocks, bonds and cash and then – at a more granular level – into sub-categories that have been shown through rigorous research to deliver higher expected returns. For example, small company stocks have been shown to deliver higher returns over time than large company stocks, and value stocks have been shown to deliver higher returns than growth stocks.
In contrast, strategies like stock-picking (trying to identify in advance stocks that will out-perform their peers or the market as a whole) and market-timing (trying to time your purchases and sales of securities in anticipation of market movements) have been shown to have a negative effect on portfolio performance.
Mistake: Chasing Short-Term Performance
If you’ve ever looked closely at an advertisement for a financial product, you’ll have seen the disclaimer “Past performance is no guarantee of future results”. Yet most investors invariably assume exactly this – that good results must be a consequence of skill and will therefore continue, and that poor results are a predictor of ongoing disappointment.
As a result, these investors will frequently move their dollars from one fund to another fund with a stronger performance track record over the past few quarters or years. In short, they’re chasing short-term performance. Why is this a problem?
Well, if past performance could predict future performance, it would be a great strategy. But when we look at the data, what do we see? Something called “reversion to the mean” in statistics. In the field of investing this means that relative weak performance is often followed by outperformance, and vice versa. So, if you’re considering switching from a fund that has recently under-performed to one that has recently out-performed, your decision may be worse than pointless – it may be the exact opposite of what you should be doing.
It’s also important to note that the perils of chasing short-term performance apply not only to switching between funds within a single asset class (for example, from US Large Value fund from manager A to US Large Value fund from manager B), but also to switching between asset classes (for example, from US Small Cap to US Large Cap).
The chart below shows the relative performance of a series of asset classes over the time period 2005 to 2019. As you can clearly see, there’s no pattern in the chart – it’s a sort of mosaic. This suggests that attempting to predict in advance from year to year which asset class will be the best performer – or even one of the best performers – is basically impossible.
Smart investors know that persistence of performance isn’t a certainty and that the best way to improve the odds of reaching your financial goals is to invest in a well-diversified portfolio that’s consistent with your objectives and risk tolerance. Stocks will provide expected growth but bring higher volatility of returns. Bonds and cash provide some income, and also dampen your portfolio’s overall riskiness. From time to time, different asset classes will perform well and poorly. But just because one is doing well or poorly at any given time doesn’t mean you should include or exclude that asset class from your portfolio.
Mistake: Not Fully Using Your Workplace Retirement Plan
Young professionals typically have a number of competing financial demands that can potentially conflict with saving for retirement – perhaps saving for a new (or larger) home, or starting or expanding a family. With home prices continuing to rise much faster than the rate of inflation in Santa Cruz, Silicon Valley, San Francisco, Portland and Bend – where many of our clients live – simultaneously saving for a home and retirement may sometimes seem like a pipedream.
But the cold hard truth is that for the vast majority of Americans – and most certainly for young professionals on a successful career path – Social Security will fund only a small portion of their retirement income needs. Fortunately, most companies today offer an employer-sponsored retirement plan, like a 401(k), 403(b), 457 or profit-sharing plan.
These plans are not perfect, but they do offer you a tax-advantaged tool for saving for your own retirement. Here are the most important things you should do – and not do – with your workplace retirement plan:
Get Your Asset Allocation Right
Asset allocation is the primary driver of your portfolio’s risk and return. It’s important to make sure that you’re well-diversified across a range of asset classes, but also within each asset class. You should, if possible, own US and international stocks (ideally large and small, valuer and growth), real estate, bonds and cash. It doesn’t make sense to own more than one fund in each asset class, since you’ll most likely just be duplicating investments – owning 100 shares of Coca Cola doesn’t make you more diversified than owning 50 shares. How much you allocate to each asset class will depend on your investment horizon, goals and objectives, and risk tolerance.
Pick the Right Funds
Once you’ve determined the right asset allocation, it’s time to implement it. At Springwater, we believe you should look for funds that are low-cost (as measured by the fund’s expense ratio), well-diversified, and “asset class-oriented”. The latter is another way of saying “not actively managed”. The fallacy of active management is a topic for another day, but you’ll almost certainly be best-served by selecting funds that invest in a broad basket of securities in each asset class and don’t attempt to pick winners or beat the market. Think: index funds. If your plan doesn’t offer them, you should ask them to!
Maximize Your Contributions
As we noted before, Social Security won’t provide enough income in retirement for you to live comfortably. So, you’ll need to save for your own retirement, ideally using tax-advantaged accounts like a 401(k) and an IRA.
Each year the IRS announces the maximum contribution limits for the various types of tax-advantaged retirement accounts it’s approved. These contribution limits are increased from time to time, to account for inflation.
For 2020 and 2021, the maximum a person under age 50 can contribute to an employer-sponsored retirement plan like a 401(k), 403(b) or Thrift Savings Plan is $19,500.
Get Your “Free Lunch” No Matter What
Of all the benefits offered by your employer, matching contributions to a retirement plan like a 401(k) are arguably the most valuable. A matching contribution is literally a “free lunch” – a risk-free return on your retirement savings that’s impossible to get anywhere else.
If you find that you’re unable to maximize your own contributions in a given year – perhaps because your income was down, or you had some unexpected expenses that impacted your cashflow – you should be sure to contribute enough to receive your employer’s full matching contribution.
Employers will often offer a 3% dollar-for-dollar match, meaning that you’ll receive a dollar from your employer for every dollar you contribute to the plan, up to 3% of your salary. For example, if you earn $100,000 and contribute $19,500 for the year (the maximum for 2020 and 2021), your employer will add another $3,000 to your account (since you contributed more than 3% of your pay to the plan, your employer matches that up to 3%, which for a salary of $100,000 is $3,000). Other employers may offer a 100% match up to 3%, plus a 50% match for the next 3%. This type of match is intended to incentive employees to contribute more of their own pay to the plan.
Rebalance Every Year
It’s probably fairly intuitive to you that not every investment in your portfolio will generate the same return every year. Instead, performance will vary between funds (or asset classes), often dramatically. Rebalancing is the practice of systematically bringing your portfolio’s mix of investments back to its intended target allocation.
The reason you should rebalance is that if your portfolio drifts too far away from its target allocation it will end up with very different risk and return characteristics. Your portfolio may end up being far too aggressive, or too conservative, depending on which asset classes have done well and which have done poorly since you last rebalanced.
One way of looking at rebalancing is to say that it’s the same as, “buying low and selling high” – which everyone would agree is a great strategy. So why do studies show that so many investors don’t systematically rebalance, and instead let their portfolios drift further and further off target? It’s because the flip side of “buy low and sell high” is “buy what has done poorly and sell what has done well”. And we know that many investors chase performance, and so will be reluctant to sell perceived “winners” or buy perceived “losers”. One way to avoid this bias is to rebalance in an objective, disciplined manner, without looking at recent fund returns, and only at their “current versus target” weights in the portfolio.
Mistake: Not Using Roth Retirement Accounts
Roth retirement accounts are one of the best wealth accumulation tools for young professionals.
Roth accounts differ from traditional retirement accounts in one significant way – when the account owner pays tax.
With traditional retirement accounts – like IRAs and 401(k)s – you receive a tax deduction for the amount you contribute to the account. Your account balance, comprised of your contributions as well as the earnings on those contributions, will grow tax-deferred. Then, when you begin taking withdrawals – typically when you’ve retired – the money you withdraw will be taxed as ordinary income. This makes sense, because you didn’t pay tax on the amount contributed, nor on the earnings over time. And the IRS eventually wants to collect what it’s owed.
With Roth accounts – Roth IRAs and Roth 401(k)s – the timing of taxation is reversed. You don’t receive a tax deduction when you make your contributions. Your account balance, though, will grow tax-deferred, as it does with a traditional account. Then, when you begin taking withdrawals, the money you withdraw comes out tax-free.
So, with traditional retirement accounts it’s “no tax now, but pay tax later”, and with Roth accounts it’s “pay tax now, but no tax later”. Since you’re most likely in a lower tax bracket today than you’ll be in when you’re older, it’s better to pay tax now at lower rates then you would in the future.
Another benefit of Roth accounts is that they don’t have minimum required distributions. This means that when you’re older and in a higher tax bracket, you won’t be forced to take mandatory distributions from your Roth account, as you would with a traditional account. Not having minimum required distributions also means that Roth accounts are excellent wealth transfer tools. If your beneficiaries eventually inherit your Roth account, they won’t be required to pay tax on withdrawals, either.