Stocks are down. Bonds are down. Market volatility is high. We are all feeling a bit frustrated with our investments this year, and we are wondering whether we need to do a portfolio overhaul. Part of this is also deciding which financial instruments are the right fir for your own personal situation.
According to Christine Benz, Morningstar’s Director of personal finance and retirement planning, “it's generally not a great idea to think about a major portfolio upheaval in the midst of the market volatility.” She would not recommend market moves as a catalyst for an investment decision, because oftentimes emotions get involved.
But if you do decide that this is the right time for you to make major portfolio changes, what should you do to ensure you’re picking the right products? We have some ideas.
First, Do Your Due Diligence
Before you even think about what to buy, it is critical that you understand the why behind this decision. Here are four steps you should not ignore:
- Step 1: Take a holistic view of your goal.
- Step 2: Determine your risk tolerance, then pick the types of investments that match it.
- Step 3: Commit to a timeline. This will give your money time to grow and compound.
- Step 4: Stick to whatever plan you have and just do your annual check in or your quarterly check in or whatever works best for you and your situation.
To help understand why these steps are so important, let’s look at two diametrically opposite scenarios in which you will need to make a decision on what financial instruments to purchase.
Scenario 1: How to Select the Right Investments for Short Term Goals
Any time you are saving for a short term goal, it's worthwhile to spend a few moments anchoring your decision-making in the numbers. Answering a few questions about this is helpful, including:
- What is the probability that you will reach your financial goals given your investment mix?,
- How much have you saved thus far?
- How much of additional contributions will you make per month?
- How many years do you have to save and invest?
Once you answer these questions, finding the right investment mix will also hinge on your own risk capacity, your risk tolerance, how flexible you are about your goal, and how willing you are to ratchet up your own savings rate if it means greater peace of mind.
According to Benz, if you are planning to buy a house within five years and you don't want to risk that your investments will be at a low ebb when you need the money, you could opt for a more conservative asset mix, even if it reduces the likelihood that you'll earn substantially more than your goal amount. If, on the other hand, you are willing to defer your house-buying date if it gives you a shot at amassing a larger down payment, you can tweak the asset allocation to make it slightly more aggressive.
However, Benz suggests don't go overboard with equities, because the portfolio should be subject to bigger short-term fluctuations than is ideal.
In selecting investments for short term goals, you can look for cash instruments and money market funds with attracting yields. As for fixed income, you must take into consideration that long-term bonds are most affected by rising interest rates than short term ones. Finally, “to the extent that you hold a sleeve of your short-term portfolio in stocks - and that's optional, especially for conservative types - focus on high-quality large-cap funds”, says Benz.
Scenario 2: Selecting the Right Investments for Retirement
Getting a handle on how much you'll need for retirement is one of the most common - and most important - financial challenges facing those of us who are still working. It is a calculation that involves many variables, some within your control, some not.
Some factors to take into consideration include:
- Your income-replacement rate
- Your retirement age
- Your life expectancy
- Your saving rate
- Your withdrawal rate (the percentage of your savings you need to use each year in retirement) and
- What (if any) public pension might be coming to you
“Retirement necessitates a look at whether you have enough to sustain you over your time horizon”, says Benz. And then, from there you can look at the positioning of the portfolio and the selection of the financial instruments.
One key consideration when selecting holdings for your portfolio is the level of volatility you're comfortable with.
If you've reacted poorly to past years’ market volatility - by selling yourself out of positions when they were in a trough, for example - you may want to emphasize downside protection.
“The main way to bring your portfolio's volatility level down is to adjust its asset allocation, but you can also reduce your portfolio's ups and downs by focusing on investments that take a risk-conscious approach to a given asset class.”, says Benz. “When assigning Morningstar Medalist ratings, Morningstar analysts take into account funds' attention to downside protection.”
If you know that you can handle higher volatility if the prospect of higher returns comes along with it, you might consider shading your portfolio toward the aggressive, putting a greater emphasis on investments that have the potential for higher long-term rewards, even though they come with higher volatility.
Don’t Forget Fees, Which Could Eat Away Massive Chunks of Your Pot
Finally, don’t forget to take a look at costs, because high fees kill the performance.
Morningstar research has demonstrated that fees are a reliable predictor of future returns. Low-cost funds generally have greater odds of surviving and outperforming their more-expensive peers. This is because fees compound over time and eat into returns. Expenses are also one of the easiest factors for mutual fund investors to control. You can’t be certain how a fund is going to perform, but you can know exactly how much you’re paying for it.
