The best retirement advice you’ll ever get
Most 401k retirement accounts limit you to the purchase of various employer specified mutual funds or ETFs. If you’re like me and have spent most of your time learning how to pick individual stocks, the idea of having to be forced into seemingly over-diversified funds can be a bit disappointing at first. Passive indexing, however, is likely the safest and most effective way to grow your funds over a long period of time. While we all are intrigued by the potential of picking winning stocks, hitting it big, and retiring early, the realist within us should acknowledge that the most prudent course of action is to save zealously and invest conservatively.
Throw your pre-conceptions aside
Most people see “investing” as a quick way to make money out of their money. Investing, in its purest sense, is the commitment of capital with the expectation of return. As a result, investment returns are simply a compensation for taking risk. In the case of the funds you’ll need for your retirement, are you really willing to assume a lot of risk in hopes of a big pay day?
The good news is that decades of research in the behavior of various asset classes has found that Benjamin Graham’s statement, “In the long run, the market is a weighing machine,” was very true not just of individual stocks, but of investment types. Over the long term, the “weight” of an investment, or its inherent riskiness, will govern the return you can expect. Generally speaking, over the history of the public markets, investors are compensated for the risk that they take on.
PLAN your retirement
Knowing that long term investing ultimately boils down to a risk/reward tradeoff, realize that investing money as part of a retirement plan is just that – planning. Don’t get googly-eyed over the potential of doubling your money every x years or the idea of turning your nest egg into a fully hatched chicken coop overnight (poor metaphor, I apologie). Most of us are planning retirements decades in the future. With the benefit of a long investment horizon, passive asset allocation is a more than adequate strategy and benefits by giving you a steady, somewhat predictable tool to plan your retirement around. Upon determining the amount of money you’d need at the point of retirement and a realistic savings plan, you can easily determine the return needed to reach these goals. Matching the riskiness of your asset allocation to the required return will allow you to comfortably target your future goals.
And, now, the best advice that anyone can give you…
Rebalance. Rebalance. Rebalance! Markets don’t move in straight lines. Though your target asset allocation may target x% average annual return, results from one year to the next can be quite volatile (the academic definition of risk).
Since, in the long run, we’re all dead, minimizing the likelihood of downside volatility and protecting your capital is the name of the game. Rebalancing achieves this in several ways.
- Rebalancing allows you to maintain your portfolio’s risk profile. As some assets outperform and some underperform expectations, your exposure to each asset’s unique risk changes from your target. This could lead to un-forseen future performance.
- Rebalancing allows you to buy low and sell high. Even though a retirement portfolio is designed to be 100% allocated for much of its life, it is still possible to “buy low and sell high.” Selling assets that have outperformed and buying assets that have underperformed effectively locks in gains from a given period and resets your portfolio at its new higher valuation to the same risk/return profile you intended, thus providing more predictable and defendable compounding of returns.
Read and learn more about asset allocation
A lot of the concepts described above involve the use of something known as “Modern Portfolio Theory.” This is the study of investments from a statistical and probabilistic point of view. If you’ve ever heard terms like standard of deviation, alpha, and beta. The study of asset allocation and portfolio theory is the main area where such concepts are applied. If you’re interested in how to construct your own lowest risk (a.k.a most efficient) asset allocations, I highly recommend reading The Intelligent Asset Allocator (my review here) by William Bernstein.
The truth, however, is that, while detailed asset allocation models give the appearance of precision, asset allocations are mostly about being directionally correct as opposed to exactly correct. You’ll never be able to explicitly pick a perfect portfolio which will yield an average of 10% per year with the lowest risk possible. In fact, you’ll never truly know if you’re succeeding until time has passed and you have the benefit of hindsight. As such, creating a passive asset allocation is more about picking a portfolio of indexes with which you are generally comfortable – using history as a rough and inexact guide. Check out my previous article on Indexing with ETFs to get an idea of how you can apply such a strategy.
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