Did you know the average investor vastly underperforms the overall stock market as measured by the Standard & Poor’s 500 Index? According to Quantitative Analysis of Investor Behavior Study by Dalbar Inc., fund investors have significantly underperformed the S&P 500 Index over the past two decades. During that period, Standard & Poor’s 500 Index yielded an average annualized return of 9.2% while the average domestic stock fund investor earned a 5% average annualized return. Due to the effects of compound interest, the difference between 9.2% and 5% over a long period of time can be devastating. See the comparison below: $10,000 invested for 40 years earning 5% turns into $40,400. The same amount of money earning 7% grows to $111,745! Simply achieving a market rate of return is one of the ways that can help prevent you from running out of money in retirement.
Unfortunately, preparing for retirement years is more challenging now than ever before.
The following steps will help you avoid the pitfalls of emotional investing and increase your chances for a comfortable retirement.
- Develop a written financial plan that focuses on your goals:
Rather than focusing on the short-term ups and downs of the stock market, focus on your progress towards achieving your retirement goals. I recommend sitting down with a family member, close friend or a trusted advisor at least once or twice a year to talk about specific goals you want to achieve in the short, intermediate and long-term. Furthermore, you should review your finances monthly in order to focus on upcoming budget expenditures. As you shift your focus to these routine tasks (and away from news headlines of unpredictable daily gyrations of the stock market), you will learn to concentrate on taking actions that are within your control and influence.
- Focus on Asset Allocation and Your Capacity for Investment Risk:
Some investors focus on the latest hot stock or mutual fund investment recommended by their neighbor, uncle or even investment gurus like Jim Cramer. However, one of the most important determinants of success in your portfolio is your asset allocation. The best way to determine the asset allocation that is right for you is to first determine your tolerance for investment risk. How much can you stand to see your investments decline and still sleep well at night? (Refer to the Financial Crisis of 2008)
The most important point to remember is once you’ve determined your risk tolerance and asset allocation with a clear head DO NOT change your investment portfolio based on short-term trends in the stock market. (Contact us for your free risk tolerance assessment.)
- Construct a written Investment Policy Statement (IPS):
Just like large institutional investors and endowments, individual investors should also have a personal IPS. A well written IPS spells out your personal investing philosophy, risk tolerance, investing goals and asset allocation. Thinking through these topics will give you the emotional strength and discipline to stick with your game plan when the going gets tough.
- Don’t let short-term events affect your long-term decision-making:
Investors often become fearful and make poor investment decisions when they see the stock market decline due to short-term events. (See latest financial “catastrophe of the day” news headline) Predicting temporary price declines in the stock market is like predicting a summer-time thunderstorms in the Southeast. It is going to happen! Stock price declines can surely cause us stress; but never forget one of the biggest risks to all investors is inflation eroding future purchasing power or even causing us to run out of money in retirement. Over a 30-year horizon, an annual inflation rate of 3% could reduce a portfolio’s purchasing power by more than half. And by the way, if you’re a married couple in your mid-fifties, one of you has a 50% chance of living to age 90.
- Do not chase investment performance:
Trying to buy past performance is like trying to drive your car while looking in the rear view mirror. It doesn’t work! You simply cannot buy past investment returns. For example, Vanguard has shown that Morningstar’s five-star rated mutual funds tend to be the worst performing investments over the following three-year period.
Once you have developed a proactive investment plan using the above steps, go out and enjoy your life knowing that you’ll outperform the average equity investor because you’re now making decisions based on discipline and fundamentals instead of emotions like fear or greed.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any information or any corresponding discussions serves as the receipt of, or as a substitute for, personalized investment advice from Leading Edge Financial Planning personnel. The opinions expressed are those of Leading Edge Financial Planning as of 27 June 2016 and are subject to change at any time due to the changes in market or economic conditions.