How Aggressively Should I Invest?
Client Question: How aggressively should I invest?
Advisor Answer: A former mentor of mine (also a financial advisor) used to always respond to this question with another question, “What is the money to you?” This often resulted in blank stares, but the point is that the particular financial goals you have should be the largest determinant in deciding how your money should be invested. This is called “Goal-Based Investing,” and you can read more about it by clicking this link. For example, let’s say a client is 35 years old and has a total of $500,000 of investable assets. Below are the goals this client has and the associated investment recommendations. You will notice different asset allocations are recommended for particular goals.
- Goal: Purchase a new car three months from now for $40,000
- Investment Recommendation: In this case, liquidity is a top priority (i.e. you need the $40,000 to be available in three months). $40,000 should be set aside now into a cash account (e.g. bank checking account). If this money is invested 100% into the stock market, and the stock market declines by 20% after a three month period, you will not have enough money in your account to purchase the car.
- Goal: Retire at age 55
- Investment Recommendation: We have a 20 year investment time horizon given that the client is 35 years old and would like to retire at age 55. Generally, money that will not be needed for 10+ years is considered to be long-term money that can be invested “aggressively.” What is “aggressively?” Morningstar, a well-known investment research firm, defines an aggressive allocation as 95% stocks and 5% bonds. They define “Moderately Aggressive” as 80% stocks and 20% bonds. You can click this link to see how Morningstar defines various levels of aggressiveness as it relates to investing.
- Goal: Make a down payment of $100,000 in four years to purchase your dream home
- Investment Recommendation: This is a situation where many clients don’t want to invest too aggressively because they need the $100,000 four years from now for a downpayment. As discussed above, four years wouldn’t qualify as “long-term” and shouldn’t be invested aggressively. Aside from investing these funds in a high yield savings account or Certificate of Deposit, you could choose to take some risk that could enhance your return. If you view the Morningstar PDF in the link above, you will see “conservative” and “moderately conservative” allocations. Depending on your risk tolerance, these allocations are more suitable for a four year time-horizon than an aggressive allocation.
Why can’t I just invest in an index fund?
Many people believe they can perform just as well as professional investors by investing all of their money in an S&P 500 index fund. I think this belief overlooks three big issues.
- Diversification: In the aforementioned Morningstar PDF, the target allocations recommend exposure to non-US countries, non-stock asset classes (e.g. fixed income), and non-large cap companies such as mid-caps and small-caps. The S&P 500 is defined as an index fund that offers pure exposure to US large cap stocks. Although this may seem very diversified, it is not well diversified relative to what is traditionally recommended.
- Defining Goals: You can see in the three examples above that an allocation to 100% US stocks wouldn’t be ideal. Defining goals and timelines should be the first part of every investment decision.
- Account Structure: It is very important to determine what types of accounts to invest in and how much to invest in certain accounts. Examples of different accounts you may be familiar with are Traditional/Roth 401(k), Traditional/Roth IRA, 529 plans, 401(a), Traditional/Roth 403(b), 457(b), 415(m), etc. The different plan rules and tax properties associated with these accounts make it extremely important to utilize them effectively. For example, I have seen that utilizing one account over the other can literally add millions of dollars to one’s net worth over a long enough period of time.
What kind of investment return should I expect?
This is a price chart from Macrotrends.net of the S&P 500 index since 1929, which was the year of the great depression (hence the big drop). No one truly knows what is going to happen in the stock market in the short term; however, history has shown the market increases in value over long periods of time. According to Vanguard.com, the average annual return from 1926-2017 for an 100% allocation to U.S. stocks was 10.3%.
One benefit of diversification is that, while some of your investments may be performing poorly, others may be doing better. This is known as owning relatively uncorrelated investments, which can lower volatility and increase returns over time. For example, investments in the the US and China will not be perfectly correlated, but they should both increase in value over time. In addition, bonds tend to be relatively uncorrelated to the stock market, so an allocation to bonds can serve as a hedge of sorts against a market decline. Below is a chart from BlackRock.com where you can see how different asset classes perform relative to others in a given year.
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