Three problems with traditional portfolios
Why investing the way "we always do" will lead to problems we never considered.
When Steve Jobs presented the iPod to the world he described it as many things, but it wasn't until he described it as "1000 songs in your pocket" that people truly grasped that the way we would listen to music had changed forever. Fast forward to today and people don't even carry music in their pocket - they stream it from the cloud.
Innovation has lead us to change how we do everything in our lives - except investing. We've largely been able to resist changing how we invest, but the time has come to eschew the financial equivalent of a gramophone and embrace a new way to invest. At Wilson Wealth we've captured this change by creating smart investment portfolios. But before we can change how we invest we have to understand what is wrong with how we currently invest via what I call traditional investment portfolios.
“Innovation has lead us to change how we do everything in our lives - except investing."
Here are three problems with traditional investment portfolios:
1. Too much risk
A traditional portfolio will typically allocate 80%, 70%, or 60% of your money to stocks with the remainder going to bonds. The difference in allocation is based on how much risk you want to take due to factors such as your age, time horizon, and financial goal. A young investor with 30 years to invest will most likely be advised to place 80% in stocks vs. a 60% stock allocation for a newly retired investor.
The problem with these allocations is that when a bear market or worse arises over half of your money is prone to loss. The last two bear markets (Dot Com Bubble and Great Recession) produced losses in the US stock market of at least 50%. Meaning that a conservative investor with just 60% of their money in the market may have experienced a 30% loss in the value of their portfolio during the last bear market. Investors with more money exposed to the market potentially endured even higher losses.
These losses are tolerable when you have a relatively small account size, but as your portfolio grows to $500,000 or higher it becomes much harder to "buy and hold" during the rough times. In fact, few investors can withstand losses in large portfolios. Seeing a $100,000 loss is tough even if it represents "just" 20% of your account. Tough enough in fact that most investors panic and sell. Which leads us to the second problem with traditional portfolios.
2. Too much emotion
You only feel good about the market after it's at or near it's peak. In other words right before it starts to decline. Conversely, you feel the worst about the market after it's fallen the most and ready to rise again. These feelings lead to emotional investing. Emotions of fear, panic, and euphoria. These emotions are amplified the more you have at risk in the market.
Jane, a mid career professional with $500,000 in a 401k and a goal of doubling her money by retirement, will have to invest 80% or $400,000 of her money in the stock market to reach her goal. In the most recent bear market, the stock market declined at least 50%. For Jane this would mean a $100,000 loss midway through the last bear market with another $100,000 to lose before the market decline ends.
How rational i.e. unemotional is an investor expected to remain in the face of such losses? What would you do if you lost $200,000 dollars in less than a year? Would you "hang in there" and "buy and hold" trusting that the market would recover?
Probably not, you'd probably sell and wait until the market was almost fully recovered before investing again. Which would feel great and seem like the smart thing to do, but actually be a big mistake because you'd be buying at a very high price. This leads me to the third problem with traditional investment portfolios.
3. Not enough opportunity to buy low
Most of the money you make on a house is made the day you buy it. No matter how much the value of your home appreciates if the purchase price is too high you'll make less money when you sell.
The same is true with stocks. The problem with a traditional portfolio is that once you've set up your stocks and bonds you rarely get a chance to buy low. When the market goes down so does your ability to buy cheaper stocks because over half (typically 60%) of your money was already invested. In most instances the best you can do is rebalance your portfolio by shifting some of the gains from your bonds into the stock portion of your portfolio.
Ex: You have a $100,000 portfolio with 80% in stocks and 20% in bonds before a bear market starts. At the depths of the bear market your stocks are worth $40,000 and your bonds $30,000. To re-establish your 80% stocks to 20% bonds ratio you rebalance to $56,000 stocks and $14,000 bonds. This allowed you to invest $16,000 at the lowest prices during the bear market.
Investing $16,000 during the worst of the last bear market paid off well, but how much more money could you have earned if you could have invested half your portfolio during the worst period of the last bear market? Wouldn't that have been better than simply "buying and holding and waiting" for the market to recover? Of course it would, but this isn't possible with most traditional portfolios.
Let's try something different
Of course traditional investment portfolios have a lot of pros, but the problem is that these pros can't outweigh the problems that these portfolios have when applied to investing for a lifetime.
Do you want to have over half your nest egg in the stock market when you are in your 70s and 80s? Do you want to be able to invest up to half your money when the stock market is at lower prices in the next bear market? Do you want to deal with the stress of seeing your $250,000, $500,000, or $1,000,000+ portfolio rise and fall from the volatility of the "next time down"? If not then it's time to try something different. Something smart.