The Three Keys to Successful Retirement Investing, Part 2


BikeAs stated in the last post, successful investing in retirement really comes down to fundamental principles more than finding the right mutual fund.  Utilize these principles to drive your decisions and you’ll be successful.  I’ll call these the Three keys to retirement investing.    These are:

  1. Contribute early and regularly
  2. Take appropriate risks
  3. Delay withdrawals as long as possible

In this series of posts, we’ll look at each of these keys and why they are important.  Today we’ll look the second key, how to take risks appropriate for you investment horizon and personal risk tolerance.

Key #2: Take appropriate risks

The first aspect of investment risk is volatility.  Let’s start there.

Volatility

Most of the time when people talk about investment risk, they are talking about volatility.  This is how rapidly the value of your investment changes. In other words, how much of your money you can lose in a relatively short period of time.  Things that are volatile like individual stocks can go up or down in price by 50% easily within a year, and can sometimes do so within a period of a few days or weeks.  In fact, stocks tend to make fast moves in one direction or another as news breaks, followed by a period where they change in price little.

Volatility is often measured by the term, beta, which can be thought of as the volatility of an investment compared to the whole market.  Stocks that have a beta of 1.0 have a volatility level equal to that of the market.  Those with a beta of 2.0 have twice the volatility of the market.   High beta stocks move up and down more than low beta stocks.

Investments that are more volatile are considered to carry more risk than those that are less volatile because their return is less predictable.  If you put $100 in a bank CD yielding 1% per year, you’ll know that it will be worth $101 in a year.  If you invest $100 in a stock index fund, it might be worth $140 in a year, or $60 in a year, or anything in between.  Stocks are very volatile when compared to bank CDs.  Because volatile investments have more risk, you want to only buy them if your potential for reward is greater.  If you can get an assured 1% in a bank CD, why would you buy a stick if the potential return were the same?  Maybe you would want to get a 50% gain from an individual stock when things work out to make up for the times when they don’t.  Let’s say that four times out of five your return is 0%, where it is 50% the other time.  By buying many stocks, you can then nearly assure yourself of getting an average 10% return overall if you can get a 50% gain when things go your way.  If the gain in stocks was only 5% when successful, you would be making the same return as you could with the bank, so it would not be worth the risk.

The return you receive is based on the price you pay when you invest.  If you’re buying an  individual stock, you need to pay a low enough price so that when earnings come in and meet expectations, the value of the stock will move up enough to give you the 50% return you desire (just to use the numbers we’ve been using).  Luckily for you, while there are some random fluctuations in price, on average stocks (and other investments) will already be priced appropriately for their risk levels due to the behavior of the market.   If you buy at several different times, as opposed to simply dumping your money in all at once, the random fluctuations will smooth themselves out and you’ll pay a price that is appropriate for the risk.  Over long periods of time, the average return on a portfolio containing a large number of stocks has ranged from about 10 to 15% per year.  This is significantly better than the returns of bonds (which range from 5-10%) and bank investments (which range from 0-5%).

So in summary, higher volatility leads to higher returns, but high volatility can also cause losses.   The trick is to use two other factors, diversification and time, to manage that risk and make it so that you are almost guaranteed to make a great return.  Let’s look at each of those aspects.

Diversification

Diversification, where you invest in more than one thing,  reduces volatility risk.  If five stocks are moving randomly, if you buy shares in all five the movements up in some will cancel out the movements down in the others most of the time since the movements are random.  This is the same as throwing a hand full of coins – you don’t know which ones will be heads and which will be tails, but you know that the result will be somewhere between 30 and 70% heads a lot more often than it will be between 90 and 100% heads or 90 to 100% tails simply because there are a lot more combinations in the 30-70% heads range than there are at either extreme.   Because the average price for stocks has a natural tendency to increase (because companies become more efficient and grow, and make more money), if you buy a group of stocks the random fluctuations in the value of the group will cancel but the overall average value will increase.

The other form of risk that diversification eliminates is the risk of bad management or random events.  If you just buy Coke stock and the Coke CEO makes a bad decision (like introducing New Coke in the 1980’s), you could see the value of your investment crater even though people are still drinking soft drinks and cola stocks, in general, are doing well.  If you buy stock in both Coke and Pepsi, however, while one of the companies may make a bad decision and cause their stock to drop significantly, it is unlikely that both will do so at the same time.  In fact, a misstep by one might provide an opportunity for the other.  It is even better if you buy shares in different industries since then you eliminate the risk of a downturn in a specific industry.  If you buy Coke and Pepsi, plus shares in a bank, and shares in a medical device supplier, while one industry may go through a rough patch where all of the companies in that industry decline, it is unlikely that three different industries would hit trouble at the same time.

It is even better if you buy shares in different industries since then you eliminate the risk of a downturn in a specific industry.  If you buy Coke and Pepsi, plus shares in a bank, and shares in a medical device supplier, while one industry may go through a rough patch where all of the companies in that industry decline, it is unlikely that three different industries would hit trouble at the same time.  The easiest way to add diversification is to buy mutual funds, index funds, or ETFs, all of which allow you to make one investment but get investments in a large number of assets.  If you buy shares in an S&P500 index fund, for example, you’ll be invested in 500 large US companies. but at a cost far lower than it would be to actually buy shares in all 500 companies.  In 401k accounts, mutual funds and index funds are normally the only choices.

There will also be times when an entire market declines.  For example, investors may be worried about an election and decide to sell their shares in US stocks.  In this case, shares of all US stocks may decline – both the good and the bad.    Note this is really the time to buy more shares since they are effectively on sale, but if you have money invested that you need soon, you may not be able to wait for prices to recover.  To guard against this risk, you can diversify into more than one type of asset.  For example, buying both stocks and bonds, or buying both US and international stocks.  In general, you try to find investments that aren’t tied to each other so that they don’t move together.  This can be difficult, but having investments in stocks, bonds, and REITs is not a bad combination, in part because the interest payments and rental income paid by bonds and REITs, respectively, help to keep them from declining in price as much as stocks when the market declines.  Of course, for short-term needs (like within five years), cash is the appropriate investment.

Time

Time frame is often forgotten when looking at risk.  Time frame will also reduce risk since you don’t need to be right about the timing for an investment to do well if you have a lot of time to wait, you just need to wait until things start to happen.  If you have a lot of time, you can reduce your diversification (but not eliminate it since single stocks or bonds can disappear entirely), since you can just wait out a market downturn or wait for the product lines of the companies you’re investing in to catch on.  In general:

Risk is proportional to:    (volatility)/(diversification x time)

More volatility causes more risk, but time and diversification both reduce risk.  In addition to reducing risk, however, diversification reduces your reward potential.   When looking at buying single stocks, adding more investments means some won’t perform as well as others.  If you just buy Coke and Coke increases in share price by 100%, you’ll do better than if you buy both Coke and Pepsi and Coke goes up 100% but Pepsi only goes up by 10% over the same period.  Diversifying into other markets also reduces your potential reward.   Because lower volatility investments like bonds don’t provide the same long-term return as higher volatility investments like stocks, diversifying into bonds will reduce the level of fluctuations in your overall portfolio value but also reduce your long-term return.

It is, therefore, better to use time to reduce risk than diversification if you have time available.  If you can stay invested for a long period of time and can just wait out market declines, it is better to hold more stocks than bonds.  As you get closer to needing the money, you then add diversification closer to equal percentages of growth investments like stocks and income investments like bonds to reduce risk since you no longer have the luxury of time.

Using appropriate risk

So to use appropriate risk when investing in a retirement account, do the following:

  1.  When you don’t need the money for a long period of time (like 20 years), concentrate more in higher volatility assets like stocks since they have a higher return.  A rule-of-thumb is to put your age minus 10% in income assets like bonds and the rest in growth assets like stocks.
  2. If volatility scares you, add more income assets that will reduce volatility (and don’t look at your portfolio value too often – a couple of times per year is fine).
  3. When you start to get close to the time when you’ll need the money, add lower volatility assets like bonds and REITs that pay out cash and have a more stability.
  4. Assume that your stocks may be up or down 20% in five years (and 50% in one year) and that your bonds may be up or down 10% in five years (and 15% in one year) and decide if you can take that risk.  For money you really, really need to have within five years, go to cash assets like bank CDs and money market funds since those are the only things that don’t go down in value.

 

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Why (Index) Mutual Funds are More Likely than Individual Stocks to Provide Gains over Shorter Periods of Time


In Using Investing to Build Up Cash for Large Purchases  it was recommended that mutual funds be used instead of individual stocks to build up money for an eventual large purchase.  This may seem an odd choice since the potential returns from individual stocks are much higher than those from mutual funds, meaning you would have the opportunity build up a balance faster invested in individual stocks than you would invested in mutual funds.  It also seems to go against the serious investing concept cited in other posts where funds are concentrated when you have little money, and therefore growth is more important that preserving your investing funds, and then diversified out into more and more stocks as balances grow because prevention of a large loss is needed to avoid losing ground once you actually have something to protect.  Indeed, a big advantage that individual investors have over mutual fund managers is the ability to select a few great stocks rather than buying everything.  This provides the possibility for individual investors to beat the markets while the mutual fund manager can match index returns at best before fees.

The difference in this case, however, is that the investor was trying to build up cash in a relatively short period of time.  True investing is a long-term proposition.  If you’re buying individual stocks you want to find companies that are well run and have room to grow.  You then need to buy in and prepare to hold them for years as the company grows and expands its business.  There are all kinds of fluctuations in the price of the stock as other individuals trade the shares based on different strategies, hopes, fears, and events in their lives.  There will also be good and bad news for the company related to the ups and downs in the economy.  There were a lot of great companies that lost seventy-five percent of their value in 2008, only to come back to their former levels in 2009 and 2010.  These kinds of fluctuations are unpredictable and part of investing.  It is the long holding periods that put the odds in the favor of the investor and make individual stock investing profitable.

In this case investing was being used to magnify what could be built up through hard work and saving with the goal of getting a large amount of cash in four, five, or maybe six years.  This could be the down payment for a home, or some cash for a new (preferably two to four year-old) car, or maybe some cash to supplement other savings for college expenses.  As discussed in the previous post, this is not true investing since the time period is not long enough to be assured of a good (or even positive) return, but instead being opportunistic and waiting for the value to increase due to a l-timed move up in the markets, then using the opportunity to sell.  This could occur in a short period of time or it may take a few extra years.  You are just giving yourself the opportunity to shorten the amount of time it will take to raise the money through work and saving alone by using stocks.

The issue in using individual stocks in this scenario is that there is a lot of volatility in the price of individual stocks.  This means that a portfolio made up just a few individual stocks will change in value very rapidly, possibly doubling or quadrupling in value, of falling by 75% or more, in a single year.  It is also very possible, and probably more likely, that a portfolio made of just a few individual stocks may do nothing in a given year, not really changing in value at all.  This is because individual stocks grow in spurts, shooting up tens to hundreds of percentage points in a period of a few weeks to a couple of months. It may then sit there for several months or maybe even a couple of years before making any other moves.

As an example, I’ve held shares of Home Depot since the mid 1990’s, buying in at prices ranging from the $50’s to the $20’s, building up a fairly sizable number of shares.  While there were fits and spurts, the stock went nowhere all through the 1990’s and 2000’s.  (For a long-term chart of the share price, go here.)  Then, in 2011, the stock started to shoot up.  At this point the stock is around $115, meaning about a 200% increase from my cost basis.  This is a rate of return of between 8 and 10%, with things currently looking bright for future gains in share price.  This compares with a rate of return of about 5% for the S&P500 index over the same period of time.  This is a good return, but it was along wait before anything happened.

Buying index funds instead, the ups and downs would have been less severe.  More importantly, the natural drift of the markets is up, so if I had kept buying shares in an index fund as I went, I would expect to see at least some positive gain within a few years since I’d be buying during both peaks and troughs in the value of the index fund.  Over long periods of time, I could do better by picking stocks and holding them (assuming I am a good stock picker) that I would do invested strictly in mutual funds.  Over shorter periods of time, however, I am more likely to have a positive investment return, adding to my work and savings, if I invest in index funds than if I were to pick individual stocks.

Got something to say?  Have a question?  Please leave a comment or contact me at vtsioriginal@yahoo.com.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What Kind of Return Can I Get From Stocks and Mutual Funds?


Yearly Returns for the Vanguard Mid-Cap and Small-Cap Indices, from Prospectus

Yearly Returns for the Vanguard Mid-Cap and Small-Cap Indices, from Prospectus

Certainly you can get much better returns from stocks and mutual funds than you can from bank accounts.  Over long periods of time stocks have averaged 12-15%, compared to 6-10% for bonds and maybe 1-3% for bank assets like CDs and money market funds.  The reason is that you are taking a bigger risk by investing in stocks than you are in the bank, so stocks are priced so that when things do work out you make enough to justify the risk that you took.  After all, if I asked you to loan me a thousand and you knew that there was a 10% chance I would not pay you back at all, and maybe a 35% chance that I would just pay you back the $1000 after a few years without any interest, you wouldn’t loan the money to me unless you knew there was a chance I might pay you back $1500 in a year or two.  That way, if you had enough people like me and you made enough loans, you could be assured of making enough from the ones who paid you the $1500 to make up for the few that just kept your $1000.  You’d need to make enough from those who did pay you interest to counterbalance even for the cases where you just get your money back and no interest, since otherwise you’d be better off just putting your money in the bank and earning 2% than to loan to those people and get no return.  The trouble is, you don’t know who is who at the start.

And that’s something you really need to understand when looking at returns from stocks and even bonds.  The returns stated aren’t regular, consistent, or predictable.  In any given year, stocks may be way up or way down.  You can’t plug 12% into a compound interest calculator and predict what your account balance will be in 1, 3, or 5 years.  To see this, look at the table below that gives the annual returns for the Vanguard Small-Cap and Mid-Cap Index Fund ETF Shares (taken from the Vanguard Prospectus) for the period from 2005 through 2013:

 

Total Return
Year Small-Cap Mid-Cap
2005 7.53% 14.03%
2006 15.79% 13.69%
2007 1.27% 6.14%
2008 -35.99% -41.79%
2009 36.31% 40.49%
2010 27.89% 25.57%
2011 -2.68% -1.96%
2012 18.22% 15.98%
2013 37.80% 35.15%

A graph of these total return numbers are shown at the start of this post.

Presented below are the values of an initial investment in the Small-Cap and Mid-Cap index of $10,000 in 2004, the total return for the full, 9-year period, and the annualized return for that 9-year period.

Value of $10,000 Invested in 2004
Year Small-Cap Mid-Cap
2005 $10,753 $11,403
2006 $12,451 $12,964
2007 $12,609 $13,760
2008 $8,071 $8,010
2009 $11,002 $11,253
2010 $14,070 $14,130
2011 $13,693 $13,853
2012 $16,188 $16,067
2013 $22,307 $21,715
Total Return 223.07% 217.15%
Ann Return 9.32% 9.00%

Note that over the 9-year period there were some very good years and some very bad years.  If you had invested in 2004, but then needed the money in 2008 and sold the shares of your fund to raise the cash, you would have actually lost a couple of thousand dollars.  You would have done even worse if you had invested in 2007, losing 40% of your investment over the next year.  On the other hand, if you had invested after the drop in 2008, you would have done spectacularly well, increasing your portfolio value by more than 150 % in the next five years.

In total, you made an annualized rate of 9.32% in the Small-Cap fund and 9% even in the Mid-Cap fund, meaning that you would have ended up with the same amount of money at the end of the period investing in these index funds as you would have received if you had put the money in a fixed income security paying a straight rate of 9.32% and 9% per year, respectively.  The way you earned that return, however, was very unpredictable and truly a wild ride.  This period of time, with the housing bubble burst causing a large decline in stocks in 2008 was certainly more volatile than normal, but there will always be times like this if you invest for a long period of time.

Note also that you would have come nowhere close to 9% if you had timed the market wrong and been on the sidelines during critical periods.  For example, if you had gotten distraught after the collapse in 2008 and sold out, you would have missed out on a 36-40% increase in 2009.  If you had thought that the market moved up too quickly in 2009 and sold out, expecting a pullback in 2010, you would have missed out on a 25% return.  Either one of these moves would have reduced your annualized return drastically.

So the real answer to the question about what kind of return you can get from stocks and stock mutual funds is that you can get between 12% and 15% over long periods of time.  This will come with some spectacular years where you earn 40% or more, and some bad years where you’ll lose 40% or more.  You won’t know during any one-year, or even three-year or five-year period what kind of return you’ll get or even if you’ll get a  positive return.  This is why you should not invest money you’ll need in a short period of time unless you can afford to lose a portion of that money.  For example, if you have $100,000 but really only need $30,000 in three years, you might be willing to invest it and take the risk of losing $50,000 for the chance of making $50,000 over that period.  If you really needed the full $100,000, however, you would be much better off just putting the money in a bank CD where you would know it would be there in three years rather than hoping that things would work out.

If you don’t need the money for 10 or 20 years, however, you really should invest the money in equities since the returns you will get will be far better than you will see in bank CDs or even bonds.  You can also then start to use a financial calculator, plug in an annualized return of 12% or 15%, and get an idea of what you account will be worth in 10 or 20 years.  You just don’t know what the value of the account will be in any given year within that period.

Follow on Twitter to get news about new articles. @SmallIvy_SI. Email me at VTSIOriginal@yahoo.com or leave a comment.

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.