Kevin is a friend who works at an area chemical plant. At age 61, he wanted to discuss his company’s 401(k) plan recognizing he doesn’t have long before retirement. Given his age, he wanted to make sure his “risk profile” was correct.
I asked Kevin how much he was deferring, how much his company matched and how his funds were invested. Kevin said he was in the “Moderate Aggressive” model.
We have heard phrases like this many times before. I asked Kevin what “Moderate Aggressive” meant.
He looked at me and started answering several times. Finally, he admitted he really didn’t know.
In our opinion, academics and the financial industry have created simplistic but non-meaningful, definitions of how investments work. They are designed to give non-financial people a level of comfort about one of their largest and most important assets. However, they fail to convey what is really happening.
Kevin’s 401(k) plan website said a Moderate Aggressive portfolio is divided almost equally between fixed-income securities and stocks. It later stated the blend was designed to “reduce risk.”
As Kevin searched online for a better definition, one said, “Moderate Aggressive values higher long-term returns and is willing to accept significant risk.”
As the soon-to-be retiree said these definitions out loud, he laughed, observing that one version “reduces risk” while the other is “accepting significant risk.” He was understandably perplexed.
The “Moderate Aggressive” model definition says nothing about the amount of income, growth or volatility a portfolio is expected to incur, especially over different time frames. It is all dumbed down into a “one-size-fits-all” bucket. More importantly, any investor needs to know how investment models function relative to outpacing inflation over short, intermediate and long time frames.
For any investor, this is a confusing topic if you don’t ask certain questions. Push your financial advisor to provide real world definitions that normal people can understand.
When we walk clients through this discussion, we recognize there is no silver bullet. All portfolios have ranges of anticipated outcomes and associated volatility. As such, ask your advisor what anticipated returns are for a recommended portfolio over 1, 5, and 10-year time frames.
Since 1950, over any one-year period, the stock market has earned as much as 47% and lost as much as 39%. If you are a short-term investor, that is a really bumpy ride. However, 10-year rolling averages for stocks over the same time have earned as much as 19% per year while the worst performance was a 1% annual loss.
Stocks are very bumpy over short-time periods, but volatility smooths over longer periods.
As I explained this, Kevin said, “What if I don’t want any risk?” Given that he was close to retirement he considered allocating all his assets in fixed income.
Even if an investor is close to a traditional retirement age of 65, they still need to manage assets for the remainder of their life. For Kevin, that means maintaining, if not growing, purchasing power for another 30 years.
In discussing this, Kevin needs to understand that if he puts all his money in fixed income assets, he will fail to keep pace with inflation. As such, 20 years from now, when he really needs the money, inflation will have crushed his purchasing power.
This brought up the fact that every asset brings multiple types of risk to a portfolio. Nothing is free of risk. With each investment decision, ask your advisor what types of risk each investment decision brings and which ones you will be insulated from. Again, there is no magic solution. Every decision has trade-offs to consider.
Although stocks are very volatile over the short run, they offer the best opportunity to maintain purchasing power over decades. Conversely, although fixed income assets may have lower volatility over shorter time frames, they are inferior at outpacing inflation over long time frames.
Understanding this dialogue, the smart investor asks a lot of questions. They know different assets have varying return and volatility characteristics, especially depending upon the time frame. Although average returns are interesting, it is imperative to understand ranges of expected outcomes. Lastly, investors must remain focused on achieving long-term success by maintaining, and growing, their wealth.
Dave Sather is the CEO of the Sather Financial Group, a fee-only investment management and strategic planning firm.
