This is the fourth installment in a series of blog posts on “The Big Five of Retirement Planning” which are the five factors that will most profoundly impact how successful your retirement plan will be. Today, we will focus on factor #4 – How hard your money works for you.
Saving for retirement is not enough, those savings must be invested and grow over time to secure your retirement. So what should you do to enable your hard-saved money to work hard for you? Here are some guidelines:
Asset allocation matters most
People get caught up in the quest for the next great stock idea. Perhaps it’s fun to share your best stock investment at a cocktail party, that’s not what carries the day when it comes to your portfolio’s long-term performance. What matters most is the mix between stocks and bonds. This “asset allocation” is what drives the risk profile of your investments and the return potential. Multiple academic studies have shown that around 80-90% of a portfolio’s return variation can be explained by the asset allocation. In other words, what determines how hard your money works is the percentage of your money that’s in stocks vs. bonds.
So, how do you know what the right mix is for you? In our view, it’s best to make the asset allocation decision in the context of a comprehensive financial plan. A retirement projection can show how different stock-bond mixes impact the probability of your money lasting until the end of your life. This will help inform your decision on whether you need your portfolio to be more aggressive (more stocks) or perhaps you can take a conservative approach and still meet your goals.
Nothing works best all the time
One of the difficulties with investing is that it’s impossible to predict which type of investment will be the all-star and which will be the bench warmer in any given year. In 2015, emerging markets stocks were one of the worst performing asset classes, losing about 15% on the year. However, in 2017 emerging markets stocks were the big winners, up over 37%. The point is nothing is the best or the worst all the time.
So how should this impact the way you build your portfolio? In our view, the key is to have exposure to all the major asset classes. This means having a mix of US stocks, international stocks, large stocks and small stocks. For bonds it means a mix of municipal bonds, corporate bonds, treasurys and so on. Have a long-term, strategic asset allocation and rebalance over time to maintain that allocation.
Take a holistic approach
Lawyers often co-invest in private investments with their clients. A few things to keep in mind here:
- Big picture – It’s important to understand what you’re investing in and how it impacts your overall portfolio risk. Private equity, venture capital and private debt impact your portfolio in very different ways.
- Size appropriately – The more illiquid and concentrated the investment is the more careful you need to be in deciding how much to commit to the investment.
- Fully understand the terms – Make sure you understand the fee arrangement and liquidity terms of the investment. Private investments often feature a couple of different fees (management and incentive) and liquidity provisions can vary greatly.
Sadly, no one can control how the stock or bond market will perform over time. That said, you can exert some influence over how your investments perform by following these guidelines and taking a thoughtful approach to how you build your portfolio.