There are many ways to invest, which leads to many ways to do things incorrectly. Unfortunately, the wide ranging studies done on investor behavior and performance indicate that doing things incorrectly is the norm, not the exception. The good news is, the truth is out there, hiding in plain in sight, and if you are willing to grab it, it will lead you down the right path.
Let’s begin this quest for truth by examining investing during our working years, and let’s use an investor in her 20’s, Grace, as our case study. Grace is a college graduate, works a full-time job, and is going to start investing today. She will use the $100 in her bank account to get things started, and then she will begin saving $550 a month until the expected retirement date of 2052. Upon retirement, she expects to need an inflation-adjusted $3,500 per month to provide for her needs. (The other assumptions are listed in the table below.) Grace is going to have three different portfolios to choose from, and each one will be analyzed using Riskalyze, which is a tool that takes into account the expected return and standard deviation of the overall portfolio, then tests it using 1000 different trials. This sort of test allows us to see what range of outcomes we could expect to experience in the future. (These tools are very helpful, but they certainly aren’t perfect. However, they will allow us to use statistics to examine the portfolios, which will give us a solid basis for comparing them.)
After running the test, on a scale of 1-100, the portfolio is assigned a moderate risk number of 56. Grace will need $1,280,500 upon starting retirement and the likelihood of her having any money left over at age 95 is 52%, with the first possible chance to run out of money in 2070, when Grace is just 78 years old. Given this result, the moderate risk portfolio (mathematically speaking) does not provide enough return. (The Chart shows the average expected return, or mean, as the bold line. The shaded area around the bold line, is the range of possible outcomes, using the 1,000 different trials)
Option 2- After seeing the results for option 1, Grace decides to increase her return by using a portfolio with a 90% US Stock (S&P500), and 10% US Bond allocation (Barclays Agg).
Like option 1, this is also a very common portfolio, except this one falls into the “aggressive category”, with a risk score of 73. (Thus, we expect more risk, and more standard deviation. A risk score near 100 would be a 100% Natural Resources Portfolio, or 1 individual stock, or anything with a very large variance) Grace will need $1,234,600 upon starting retirement. Since we increased our expected return, we can see that we get a much better result, with a 92% chance that we have money leftover at age 95. (We can also see that have we have a much larger range of values, which you can see shaded in blue.) The first time that Grace could run out of money is in 2078 when she would be 86.
Option 3- Lastly, Grace decides to put Modern Portfolio Theory to the test, by building a portfolio using multiple asset classes, diversified globally. (Stocks, Bonds, Natural Resources, Real Estate, Managed futures)
The portfolio is assigned a risk score of 56, which is exactly the same as Option 1. However, the results are quite different. Grace will only need $1,108,200 at retirement and she now has a 92% chance that she will have money leftover at age 95. (instead of 52%) The first possible time that Grace could run out of money is in 2082 when she would be 90. It’s clear that Grace’s expected return has gone up and that her standard deviation, or risk, has gone down. Thus, her portfolio is behaving like a 73 for returns, and a 56 for risk.
After running the tests, Grace can now see that her investment strategy will make a significant impact on her future.
Option 1, which is a moderate risk option, is actually the worst option of the three. (This is a perfect example of why risk, or your risk tolerance, shouldn’t be the only factor that is used to choose a portfolio.) The second portfolio, which represents most US Investors, will most likely get the job done, but it’s not efficient, and the returns will vary widely, which increases the chance of Grace bailing on her strategy. Option 3, a properly built portfolio, allows Grace to reduce her risk and increase her return, giving her the best of both worlds. Investors like Grace, that are working and investing for retirement, regardless of their age, would be wise to use math, and not myth, in order to support their investment strategy. (Unless getting the optimal result is not important to them!)
*All data is used for illustrative purposes only. Actual investment results will vary.