What does saving for retirement mean to you? If you’re the average investor, it likely means making a contribution to your retirement plan with each pay check, and possibly reallocating into different mutual funds from time to time, depending on where you see the economy going. While there’s nothing inherently wrong with this plan, our view here at Fisher Investments is that using an average retirement strategy is most likely to end with an average (or even below average!) result.
And when it comes to investing, the average person is going to be wrong far more of the time than right. It’s a simple fact that, as humans, our natural emotions and pattern-seeking behaviors often work against us when making decisions about investments. We’ll buy when we see a stock rocketing up an exchange, ignoring the fact this trend can change in seconds. We’ll cash out our equities when they significantly drop to avoid the painful loss, without considering whether they are likely to rebound even more when the market turns.
To be more effective in planning for your retirement, you need to know where you want to be at retirement time and consider carefully the path to get there. Accomplishing this goal through modern, hectic markets requires a careful analysis of your current financial situation together with your future needs and, critically, your time horizon. Unlike many firms, we don’t feel that your tolerance for risk should be the overarching determinant in your retirement strategy. Rather, there are other factors that should drive how much risk you’ll need to tolerate to reach your goals.
So, let’s discuss some common misconceptions investors have around how risk is created in their retirement strategies, and how you can potentially avoid those risks.
If you really dislike someone, you should give them a brokerage account and have them Google this phrase. There are countless recommendations available—some fair, some dubious and some downright dangerous. But believing in a single, “best” strategy that will help anyone successfully reach their retirement goals is a serious risk to your investing.
No two investors will have the same goals, be in the same personal situation or react to markets the same way; consequently, there’s no one solution that can reliably work for everyone. The following is just a sample of factors you should consider in order to develop a personalized retirement strategy:
Dispelling the idea that there is a “best” way to reach retirement is an important step for investors to take in protecting themselves against self-inflicted losses. Once every decision is viewed through the lens of your specific situation, it becomes much easier to see how a particular retirement strategy is or isn’t appropriate.
If passive investing was as easy as it sounds—buy some index-tracker funds on a strong benchmark and lock the documentation in a dark room until you reach your retirement—then everybody would be doing it effectively, and there would be no place for active management. In theory, this kind of investor just holds on and comes out smiling by remaining resistant to the scares and temptations of the market. But if passive investment was really the simplest of retirement strategies, then the world would be full of 70-year-old millionaires.
Yet, being a true passive investor requires extreme discipline that many people struggle with. Generally, when investors perceive uncertainty (whether economic, political or personal), it is met with emotion. Almost inevitably, this subjective bias influences investment decisions, particularly during times of market peaks or troughs.
Studies conducted on aversion to loss have found that we feel the negative impacts of a loss twice as much as the positive impacts of a gain. What this means for investors is that even relatively modest volatility or downturns can lead us to panic and attempt to stop the losses as quickly as possible, often causing overreactions to short-term changes by pulling money out of the market and failing to re-enter before it recovers. Conversely, in times of bull markets, we frequently need to see exceptional performance before we’re willing to shift from our present course. The result is much—or all—of the potential gains have already occurred and the stock is overvalued by the time we are ready to buy in—an effect called “chasing the market” or “chasing heat.” This is why emotion is really the downfall of effective passive investment retirement strategies. As soon as you let your feelings drive you to an action, you’re no longer a passive investor.
On the other side, a good active investment manager has the experience and analytical resources needed to help investors avoid the myriad pitfalls of investing. It’s important to remember that the average investor is most often wrong, and many of the savviest investors known for consistently beating the overall market are only right around half the time. While it’s wise to choose a money manager who does regularly out-perform their chosen benchmark, these services cannot necessarily be weighed against the benchmark alone. As we’ve discussed, having the discipline to endure the ups and downs of a passive approach is something many struggle with, so it’s also valuable to consider how your investment adviser may help prevent you from making a costly error in judgement.
In some ways, the whole passive vs. active debate creates a false dichotomy. Either method can succeed or fail. But, the outcome isn’t simply a factor of the retirement strategy you choose—it’s more a factor of who you are as an investor.
What you truly need is an asset allocation that stays aligned with the goals of your retirement strategy—whether that’s through a manager making investment decisions or simply by trusting in the economy to do the work over the long haul. The key in either case is to stay disciplined and follow your plan. The difference is that with an active manager, you have someone knowledgeable there to help you steer a steady course when emotions and uncertainty arise.
In the retirement strategies of many Americans, bonds are attractive due to their reputation for safety and resilience to near-term volatility; but in reality, this perception comes at a cost. Bonds also have lower longer-term returns than stocks (as an asset class1) and don’t have the same potential for growth that you may need to help ensure an adequate return during your saving years to fund your retirement lifestyle.
Consider the following analogy: It may be safer to never leave the house, but it will never be as rewarding as living a life in which you are prepared to embrace variety and opportunity. The truth is stocks as an asset class have, historically, more uniformly positive returns than bonds over the long term. Inevitably, there will be down periods of corrections and bear markets, as well as specific stocks that are wiped out as businesses fail. But, bull-market cycles tend to be both larger and more numerous, making up these losses with stronger gains (as you can see in our study on the matter), and a diversified portfolio can help protect against the individual securities that have lost value.
To their credit, bonds are excellent tools for generating consistent income (compared to the potential irregularity of stock dividends) and they generally provide more protection against principal loss than stocks; but you should remember that bonds also carry risks. While liquid, their value is affected by interest rates—when prevailing rates fall, bonds with higher rates become more valuable, while those with lower rates become less so. Given that US Treasury bond interest rates have broadly remained low since the 2008 financial crisis2, these vehicles may prove wholly inadequate to offer the growth needed to reach your investment goals when used as the primary asset class.
In addition to potentially leaving you with a funding shortfall in retirement, there are many other types of risk associated with bonds. These include the following:
To call bonds a low-risk investment is to misunderstand the many complexities of risk. While they may represent a useful way for some investors to protect principal and generate retirement income, they can also represent an opportunity cost for those who still need significant growth to reach their goals. Retirement strategies should always be developed to address the particular risks most likely to impact that individual investor, and how a specific asset contributes to or mitigates those risks can vary greatly.
By enabling investors to pool their assets and purchase a collection of securities they might individually be unable to acquire, mutual funds have long been a way for investors to diversify their accounts, even with modest sums. Although mutual funds can be useful in mitigating single-stock risk for smaller investors, they can be much more inefficient at a larger scale or when overused.
For one thing, with multiple funds you can actually create risks of overexposure to specific sectors if you don’t watch out for overlap in the securities in which the funds are invested. There is also the risk that your funds work at cross purposes, such as one fund selling a security that another buys. In this case, your portfolio hasn’t changed, but you’re likely to end up charged with numerous fees from the funds at both ends.
There is also additional risk of higher fees with mutual funds when compared to purchasing securities directly. Mutual fund fees can snowball quickly, especially in the case of active mutual funds. While these costs may be worth absorbing to small investors in exchange for diversification, those with sufficient funds to invest directly in a diversified portfolio of stocks can usually achieve a similar position much more cheaply. Depending on where they are purchased, mutual funds may also present a greater risk of loss due to taxation. Unless a fund is owned through a tax-advantaged account (like a 401(k) or IRA), the fund’s owners pay taxes on the gains of each sale, even if the proceeds are immediately reinvested. Depending on the frequency of trades, capital gains distributions and account performance of a given fund, this situation could result in a significant current tax burden without income to cover it.
Many of the drawbacks that apply to mutual funds also apply to exchange-traded funds (ETFs), as they are similar products. ETFs hold other securities, owned by a pool of investors, to provide diversification, so they can still create areas of overlap, if poorly selected. However, they do pose different risks in retirement strategies.
For example, some ETFs try to mimic an index (like an index mutual fund).Consequently, these ETFs tend to have lower fees and trading expenses that can eat into their returns when compared to actively managed funds. This is why they are often sold to investors seeking a passive strategy. However, as we discussed, investors often struggle with remaining passive. While mutual funds are bought and sold at prices based on their previous-day value, ETFs can be traded freely in the market throughout the day. Being able to see this active movement and having the ability to immediately respond to market changes makes using a passive ETF strategy incredibly difficult for the typical investor. Using ETFs passively requires long-term discipline, and people are often simply too emotional to weather all the challenges thrown at them. So, you could be greatly increasing your risk of making a mistake using this approach.
Annuity salespeople may promise market-like growth with little or no risk. But the reality of annuities is that they are still just insurance policies at their core. Fundamentally, the proposal they offer doesn’t even make much sense if your goal is growth. How could you reasonably expect more return from an annuity than from a security, when an annuity’s provider is simply charging you an extra fee to invest in that security for you? In our view, there’s only one place for annuities in a retirement strategy: to protect against longevity risk, or the possibility of outliving your retirement funds. For growth, keeping pace with inflation and supporting your retirement lifestyle, annuities usually present many more problems than solutions.
You may hear about all sorts of “guarantees” when talking with your friendly annuity salesperson. However, the only thing that actually matters in the end is your annuity contract. These can be difficult to understand for a typical investor, and no wonder: Annuity contracts can be as thick as dictionaries. As these contracts are often cluttered with opaque terms and conditions, what you think you hear from your annuity salesperson may not ultimately be what you expected (or even in your best interests). Many of these terms, such as “Guaranteed Lifetime Withdrawal Benefit,” “Guaranteed Minimum Income Benefit,” “Enhanced Earnings” or “Tax Coverage Death Benefit” (and, really, most features that can make annuities attractive) are actually optional “riders.” To include them, you typically pay some type of additional annual fee or charge, which can build on the already-considerable fee burden of most annuities.
In fact, annuity fees can eat into your principal fairly significantly. And so-called “exit” or “surrender” charges are deliberately high to discourage you from leaving. But there is another reason why our Annuity Counselors have seen contracts with these charges as high as 20%: The insurer wishes to recoup the sales fee or commission paid to the agent or broker who sold the annuity in the first place. So, it is natural to ask: If annuities are so great, why do they have such high surrender fees and commission rates?
As you can see, there is no such thing as one-size-fits-all when it comes to retirement strategies. One thing is certain, though: The time to begin planning your retirement is as soon as possible. The sooner you get started and the more you invest at an early stage, the greater your returns are likely to grow through compounding. And, the longer you’ll have to identify and address your risks, leaving you more likely to enjoy what should be the most comfortable chapter of your life.
That's why it is always our goal at Fisher Investments to get a full picture of our clients’ finances, so we can expediently provide them with customized strategies to fit their personal situations, retirement goals and time horizons. To learn more browse our selection of retirement planning guides, or request an appointment today.
1 Source: FactSet Global Financial Data, as of 07/12/2017. Since 1926, stocks have posted annualized returns of 10.0%, outperforming corporate bonds, gold, US Treasurys and municipal bonds.
2 Source: analysis of daily 10-Year US Treasury Bond rates from 1/2/08-8/7/17, as listed at https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield showing no rates passed mean rate of 4.58% calculated using data from Robert Shiller going back to 1871 at http://www.multpl.com/10-year-treasury-rate