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Sound Advice: January 20, 2021

The problem with most investment accounts

Most people are not equipped to handle their own investments.  Everyone is looking for substantial rewards, but most of us ignore the fact that greater potential for reward means more risk is involved. 

How do you limit risk? By diversifying.  But that's usually the hitch.  Just because you own a half dozen mutual funds or stocks doesn't mean your portfolio is diversified.  More often than not, it will mean just the opposite if the underlying holdings of the funds you hold are similar, which they often are.  That's frequently the case with stocks, too.  If you hold a dozen stocks in related industry sectors, that will magnify, not lessen, the overall risk.

The goal of diversification is to hold a variety of securities that don't all move in the same direction.  Equities do well sometimes and are extremely disappointing in others.  During periods when interest rates area being reduced, bonds do well.  When rates are rising, they do poorly.  Real estate goes through boom and bust cycles, too. 

So individual holdings are akin to individual threads. By themselves, they are not strong.  When knit together from differing asset classes, they form a fabric that can be greater than the sum of its parts.

 

A properly diversified portfolio will consist of holdings in at least a half dozen asset classes: equities – domestic, developed international, and emerging markets; fixed income – domestic and international; and alternative investments.  Each asset class will be populated by actively managed funds, passive investments (those that follow an index) or well-selected individual stocks or bonds.

The overall asset allocation will reflect factors specific to the individual investor.  The most important factors are time horizon, investment experience, risk tolerance, and the need for current income.  Younger and more risk-tolerant investors seeking increased returns may have portfolios heavily skewed towards equities.  They can do so because the risk of owning equities diminishes steadily as time periods extend. 

Investors in or near retirement will need portfolios with greater stability and reduced risk exposure.  If their time horizons are short and the market plunges in-between, there may not be sufficient time to recover.  Portfolios of those investors will depend more heavily on short- or intermediate-term, fixed-income investments, where the risk to principal is under better control.  

In this era of prospectively more moderate returns, the cost of investing has become more important.  Four decades ago, when brokerage commissions were largely fixed, it usually cost $100 or more to buy or sell a stock.  These days, there are no commissions. In the early days of mutual funds, sales charges often ran as high as 8%.  Now, many mutual funds are available with no sales charge.  And there are also exchange-traded funds offering participation in different industry sectors, asset classes, as well as regions or countries around the world.  Here, too, there are no commissions.

But there's more.  With funds, there are expenses.  With actively managed funds, there is also the cost of managing these funds.  All of these add up.  As underlying costs rise, the prospective returns to investors are reduced.  So in addition to the cost of buying into these funds, one needs to look closely at the cost of the funds themselves.  In some cases, that can be as low as 0.05%, but in others it can be as high as 2% to 3%.

As if all of this isn't enough to consider, there's the temptation to think that past results will provide some degree of assurance that the future will be more of the same.  A perfect example is a mutual fund with an excellent record over the last three or five years.  But if the fund manager leaves and a new manager takes over, guess what?  It 's a new fund.

Investors need to be informed.  Few really are.  Although there's an overwhelming amount of information available about investing, the challenge is figuring out what's important and what can be ignored. 

Much that comes out of the media is of little value.  When the market goes up hundreds of points based on a snippet of good economic news and then drops by the same amount the next day when investors react poorly to talk of rising interest rates, you have to wonder what's wrong with this picture.  The best advice is to think of day-to-day events as you think of the weather.  Weather can be unpredictable, but we know for sure that summer brings warmth and winter means bundle up.  It's the same with investments. 

One has to take the broader view to understand what's going on.  What happens in the short term is essentially unknowable.  Even so, as time extends, disciplined investing pays off.  Any given year or two may be disappointing, but a properly constructed portfolio will provide worthwhile returns over time while limiting exposure to risk.

 

N. Russell Wayne, CFP®

Any questions? Please contact me at nrwayne@soundasset.com

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