Most of us hate uncertainty. Unfortunately, picking investments almost always involves uncertainty. This is obvious if you review the long list of investments available to include in, say, a 401k investment menu. That’s because while you can look at the past performance of each investment, you ultimately have no way of knowing which investments will perform well in the future.
While we can look to financial analysts and forecasters for help, it’s rare that their predictions work out consistently. And worse yet, many people tweak their outlooks to tell us what we want to hear — so we’ll watch their shows, read their columns, or buy their books. So how can you go about picking the investments to include in your retirement account, or your portfolio overall? Here’s the guide I discuss with clients.
Start with your 401k
Your company gives you a 401k investment menu that should tell you how each of the investments performed in the past, usually over one-, three-, five- and 10-year periods. Some menus might include star ratings from a noted rating agency. You may conclude that your company hired a great investment mind and painstakingly selected this menu so any choice is a good one. Or you might rely on picking the investments with the best past performance.
This is called “track record investing,” and basically means you are trying to pick which assets that performed well in the past will continue to perform well in the future.
The problem with this investing strategy is: past investment performance does not predict future results.
If that warning (past performance does not predict future results) sounds familiar, it’s because the Securities and Exchanges Commission (SEC) requires mutual funds to make that disclosure to potential investors. Why? Because academic studies, as well as the principles of modern investing, all show that track record investing has little value. Similarly, picking a fund or money manager based on their track record rarely works. Fortunately, there’s a better way to pick investments.
How to pick investments
During my MBA studies at MIT Sloan, I studied modern portfolio theory. I won’t get into too many details, but essentially a number of scholars defied Wall Street to come up with a new theory for how to combine stocks, bonds, and cash. They attempted to balance potential returns with the amount of risk (potential losses) an investor was willing to take on. These scholars discovered that generally speaking when you take a couple of different investments and combine them in different ratios, you get predictable outcomes.
Put another way, the power of a portfolio came not from which stocks and bonds you pick, but from the ratio of stocks to bonds over time. In fact, they noted you’d get better results if you simply took a group of 500 or so stocks and accepted the average. This took away the risk of picking the wrong individual stocks. This approach generally works best over long time periods, when the highs and lows all investments experience tend to even out.
Do you need a financial professional?
I have yet to see a 401(k) menu that provides the information or education necessary to help participants create a modern, goal-based portfolio (using modern finance theory as described above). That’s why I believe the best approach is to find an investment advisor to help you. Just make sure the advisor is a fiduciary, or legally obligated to work in your best interest.
At Envision Wealth Planning, we use a modern finance technique to help you pick the right investments that are best for you. Our first step is to figure out your goal. Then, we figure out the combination of investments most likely to get you there.
So for example, with retirement investing, we figure out how much income you think you’ll need in retirement. We use that to figure out the total retirement savings you’ll need. Next, we look at how many years you have until you retire. From there, we can determine how much market risk you need to take to hit your average return targets. And we help you build a portfolio, or pick the investments in your 401k, accordingly.
To learn more, contact us for a free consultation.