#1: What works for my neighbor/friend/sibling/co-worker will work for me.Your idea of a perfect vacation may involve a book and a beach, while your neighbor prefers climbing Mt. Everest. Similarly, the risky sector-specific stock fund your neighbor swears by may be a stark contrast to the balanced all-in-one fund you prefer. You’re unique. Your portfolio should be too.
The first—and most important—decision you make when building your portfolio is choosing your asset allocation (the mix of stocks, bonds, and cash investments you hold in your portfolio). Then you can pick your individual investments.
“Your asset allocation is the driving force behind your investment returns and how much the value of your portfolio will fluctuate in response to market activity,” said Tony Giordano, a financial planner in Vanguard Personal Advisor Services®. “The individual investments you hold should align with your target asset allocation and provide diversification, so no single investment can control how your portfolio is impacted by market movement.”
It can be helpful to talk about money matters with friends and family, but do your research before making an investment decision. Start by taking our investor questionnaire to find your target asset allocation; then get a mutual fund recommendation online.
#2: I’ll know when to get out of the market—and when to get back in.Easier said than done. Getting out of the market to avoid an anticipated drop in the value of an investment and/or getting into the market to take advantage of an anticipated increase requires a degree of clairvoyance that eludes most of us (professionals included).
“Market-timing requires investors to make changes to their asset allocation in response to current events alone, without regard for personal goals, risk tolerance, or time frame,” said Giordano. “When you make changes to your portfolio based on assumptions about how the market is going to perform, the only information you can use to make your decision is past performance—which doesn’t predict future success.
For example, as of December 31, 2008, 2,301 funds outperformed their benchmarks. Five years later, only 501 (22%) of those previously high-performing funds outperformed their benchmarks.”
Sources: Vanguard and Morningstar.
#3: To avoid risk, I’ll avoid stocks.Because stocks are more volatile than bonds or cash, keeping them out of your portfolio makes your portfolio essentially risk-free, right? Wrong.
Steering clear of stocks in an attempt to avoid market risk can expose your portfolio to other longer-term risks, including shortfall risk and inflation.
“If you pack your portfolio with low-risk, low-return investments, you may not achieve the growth you need to achieve your goals. This is called shortfall risk. Investors with limited guaranteed income from employment, Social Security, etc. may be especially vulnerable to this risk,” Giordano said. “When you take on little risk and receive little reward, you may be forced to increase your savings rate to meet your goals, which can put excessive strain on your current income—and a lot of stress on you.”
Another risk is inflation: Your portfolio may not grow as fast as prices rise, resulting in a loss of purchasing power over time. “$100,000 in savings today will only be worth $55,367 in 20 years at a 3% annual inflation rate,” added Giordano.
#4: You get what you pay for: Higher costs = higher returns.Sometimes price directly corresponds to quality: You pay more for a first-class plane ticket, you get more: preferential boarding, a bigger, more comfortable seat, and more than just pretzels to snack on. No such correlation exits in investing. In fact, the less you pay to invest, the more investment return you get to keep.
“This isn’t a novel concept. We comparison-shop all the time and make decisions accordingly,” Giordano said. “Let’s say you plan on selling a $500 item at a consignment shop. One shop will keep 60% (the industry average) of the $500 sale price. So when your item sells, they’ll keep $300, and you’ll walk away with $200.
“The other shop will keep 10.8%, which is 82% lower than the industry average.* They’ll hold onto $54 of the $500 sale price, and you’ll pocket $446. Which shop would you rather consign with?”
Next time you’re tempted to act on a thought that pops into your head, challenge your logic before taking action.
Now, what do you think?
“If you don’t think you can talk yourself out of believing in an investing urban legend, don’t worry. That’s what financial advisors are for—they know the difference between fact and fallacy, they understand investing, and most important, they know how to support you so you don’t get in the way of your goals,” said Giordano.
*The average Vanguard fund expense ratio is 82% less than the industry average. Vanguard average expense ratio: 0.18%. Industry average expense ratio: 1.01%. Sources: Vanguard and Lipper, a Thomson Reuters Company, as of December 31, 2015.
All investing is subject to risk, including the possible loss of the money you invest.
Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.