When it comes to how you behave around money, and specifically your financial behaviors around investing money, instinct is not always a good guide — in fact, it often drives one to take exactly the wrong action. Working with a financial advisor is a great way to counteract this tendency, because they can help you choose the financial behaviors that are best for you — no matter how strongly your instinct tells you the opposite. Let’s look at two examples of this effect.
For the great majority of young people, financial planning and saving are not things they think about much, if at all. That’s a shame, because when one starts practicing smart financial behaviors as a young person, it makes an enormous difference over the course of their life — thanks to the impact of compounding returns.
As the graph below demonstrates, people who begin saving at a young age can end up with significantly more money when they reach retirement age than others who save at the same rate, but start later. Of course, this is not to say that there’s an age at which it’s too late to start saving — rather, the sooner you start, the better you will do.
This example is purely to illustrate the point that starting early maximizes the benefits of compounding returns – giving you a long time-horizon over which your money keeps earning money. Working with a financial advisor can help you start learning sound financial behaviors, regardless of your age. The advisor’s job is to not only develop a customized, comprehensive plan for you, but also help you stick with it over the long haul, so that you get the results you need.
Here again, most people’s intuition tends to reinforce exactly the wrong behavior.
The same holds true for any type of undiversified investment — whether it’s individual stocks, specific mutual funds, or even entire market sectors. Most people’s instinct is to go with a proven winner. That’s understandable, but when you do, your investment may not have as much room to grow in value. But the bigger problem is that you’re assuming the past performance of the asset will continue in the future, and the data just doesn’t support this.
Last year, our broker dealer released a study comparing the investment performance of eight different asset categories (cash, fixed income, U.S. large-cap equity, etc.) with that of various well-diversified portfolios that ranged along a continuum from ultra-conservative to aggressive growth.
*Figure 1 shows some of the data that appeared in the study. A key takeaway from this table is that the diversified portfolio has a more consistent performance year after year than any of the other individual asset types. In the table, the Moderate Allocation portfolio (represented in gold) had an annualized return of 6.3% over 20 years, placing it near the middle of the pack. Just as crucially, even though it lost value in the crash of 2008, it outperformed all other asset categories referenced that year, except for cash and fixed income.
A portfolio can — and generally should — be diversified in several dimensions. It can include U.S. large-cap and small equities, different types of international equities, real estate securities, fixed income (bonds) and even commodities.
The bottom line is that diversifying your investments reduces risk and volatility — and that allows you to have a great deal more confidence that you’ll have the resources you need to do the things you want to do now, and when you retire.
*For more detail, refer to Figure 1. Comparisons of various broad-based asset classes’ performance, 1999-2019
Cash is defined as the Bloomberg Barclays 1–3 Month U.S. Treasury Bill Index, which is an unweighted index that measures the performance of one- to three-month maturity of U.S. Treasury bills.
Fixed income is defined as the Bloomberg Barclays U.S. Aggregate Bond TR Index, which covers the U.S. investment-grade fixed-rate bond markets, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Investing in fixed-income securities involves credit and interest rate risk. When interest rates rise, bond prices generally fall.
Domestic large-cap equity is defined as the S&P 500 TR Index, which is a free-float market capitalization index of the 500 largest publicly held U.S.-based companies, capturing 75-percent coverage of U.S. equities. It is often used as a proxy for the American stock market.
Domestic small-cap equity is defined as the Russell 2000 TR Index, which measures the performance of the smallest 2,000 U.S.-based companies in the Russell 3000 Index and serves as a benchmark for U.S. small-cap stocks. The equity securities of small companies may not be traded as often as equity securities of large companies, so they may be difficult or impossible to sell.
International developed equity is defined as the MSCI EAFE GR Index (Europe, Australasia, Far East), which is a free float-adjusted market capitalization index that is designed to measure the equity performance of 22 developed markets, excluding the U.S. and Canada. The MSCI EAFE Index is commonly used as a benchmark for equities representing the developed world outside of North America. International investing presents certain risks — like currency, custodial, political and transparency risk — not associated with investing solely in the United States.
International emerging market equity is defined as the MSCI Emerging Markets GR Index, which is a free float-adjusted market capitalization index that is designed to measure equity performance in the global emerging markets. Investing in emerging markets involves greater risk than investing in more established markets due to exchange rate changes, political and economic upheaval, and low market liquidity.
Real estate securities is defined as the FTSE NAREIT Equity REIT TR Index, which includes all equity REITs trading on the NYSE, Euronext and the NASDAQ OMX. Equity REITs are defined as firms that own, manage and lease investment-grade commercial real estate. Investing in a non-diversified fund that concentrates holdings into fewer securities or industries involves greater risk than investing in a more diversified fund. Changes in real estate values or economic downturns can have a significant negative effect on issuers in the real estate industry.
Commodities are defined as the Bloomberg Commodity TR Index, which is a diversified benchmark for commodities and is composed of futures contracts on physical commodities. It uses both liquidity data and U.S.-dollar-weighted production data in determining the relative quantities of included commodities. No related group of commodities (e.g., energy, precious metals, livestock or grains) may constitute more than 33 percent of the index. Standard deviation is an indicator of the portfolio’s volatility around its average annual return. The larger the portfolio’s standard deviation, the greater the variability of the portfolio’s annual return.
Diversified portfolios assume annual rebalance at year end. The returns of the asset allocation example assumes an annual rebalancing back to original weights and the linking of monthly returns. The results shown are not the actual performance figures for any particular client. Source of returns: Morningstar Direct. (Jan. 1, 2000 through Dec. 31, 2019).